As you might have guessed from the title, I’ll use this post to go over five specific IPO planning mistakes to avoid. These are all things I’ve seen clients do when preparing for their IPOs, so I want you to be aware of them.
But before we jump into that list, and almost more important than knowing what the mistakes are, I want to talk about where these mistakes come from.
What causes people to make these IPO mistakes, in other words?
In short: anxiety.
The biggest thing I see in my clients, that you might be experiencing as well, is a general sense of anxiety over such a huge life event that can lead you to overthink things.
It’s crucial to know that there’s no ONE perfect way to approach an IPO, and the most important thing is to focus on YOUR big picture, and what you want that to look like.
From there, you’ll be able to reverse-engineer a great IPO plan for yourself.
Before you choose your “official” IPO strategy, it’s a good idea to take a deep breath, and take a step back from all the tiny little specifics you’ve been researching over the past weeks.
Instead, look at the big picture. Go back to your original stock options grant, and compare the price of those options to the expected IPO price.
In most cases, the current stock price is 10x or more than your original exercise price, so you’ve already won in a BIG way. ????
Of course, we’ll do our best to put together the best stock option plan for you (by reducing taxes, maximizing cash, etc.), but it helps to realize how much success you’ve already gained just by having an exit. Regardless of any of the tiny, stressful little details, you’re still winning in a major way.
With that in mind, here are five IPO planning mistakes to avoid to make sure that win is as big as possible:
Mistake #1: Using Limit Orders
When you’re going through an IPO, there are a lot of new things to think about, including HOW you sell your shares in the market.
The different ways to sell are called order types, and the two primary order types are market orders and limit orders.
Market orders basically state, “I want to sell _[insert number]_ shares at the best current price someone is willing to pay.” When you do that, your custodian (wherever your shares are held) will go into the market, offer your number of shares, and take the first and best price they can get without delay.
Basically, you’re deciding to sell right now at whatever the market price happens to be.
A limit order, on the other hand, is where you specify the price. You’d usually set the price a little higher than what the current market rate is, and your order will only close (sell) if you get your specified price. If you don’t get your desired price, your order expires, and the shares don’t sell.
I’ve found the idea of limit orders to be really popular with clients when they’re planning for their first trading window after an IPO. A lot of people think it’s a good idea to set a number of different limit orders at different prices, because they feel like they’re being smart and making the “perfect” IPO plan.
Unfortunately, they’re not.
There is absolutely no way of knowing what the market will do on the first trading day.
A lot of people like to base their plans on recent IPOs of similar companies, thinking they can extract useful information from past IPOs, and it’s just not true.
When you’re dealing with an IPO, you’re dealing with one stock on one day. There is no average or historical precedent for what will or won’t happen.
What can happen, unfortunately, is limit orders get set at a price slightly higher than the current market rate, but those orders never fill. The timing is off, and the market takes a turn for the worse.
For example, if a stock is trading at $40 and you set a limit order at $41, the limit order might never fill because the price either doesn’t go up, or because it goes down. Then, because your order didn’t fill, you’ve got all these extra shares, and it’s totally possible that the share price will fall even lower (to $20 or less) after the trading window closes. I’ve seen this happen, and it’s really unfortunate.
If you find yourself in that situation, you’ll really wish you’d have sold at $40, instead of setting a limit order and holding out for the $1 extra per share.
It’s totally fine if you don’t want to sell everything at once and decide to do a number of different trades during your first trading window… but use market orders to do this. Don’t add the extra layer of complexity and risk a limit order gives you.
Mistake #2: Waiting Until the Last Day of the Trading Window
Similar to avoiding limit orders, waiting until the last day of your trading window will leave you running out of time and missing opportunities.
It doesn’t matter if you want to exercise and hold, sell shares, or both.
Do not wait until the last day to do these things. Know what your plan is going in, get organized, and be ready to execute on that plan at the beginning of your trading window.
More than likely, you’ll only have four trading windows per year, each lasting about 4-6 weeks. They’re not long, so you must be ready to act.
Why?
Here’s a scary example from one of my clients:
During the last couple of days of the trading window, my client exercised and held a large amount of incentive stock options (ISO), triggering a HUGE amount of alternative minimum tax (AMT).
If they hadn’t waited so long and exercised on day one of the trading window, the shares would have qualified for long-term capital gains one year later. This would have given them enough time in the SAME trading window next year to sell those shares before April 15 so they could have enough money to cover the AMT on the exercise.
But since the options were exercised and held on the last day of the trading window, the calendar dates didn’t line up.
The shares qualified for long-term capital gains only after the trading window closed, eliminating the opportunity to sell the shares at a significantly lower tax rate.
This meant my client had to come up with the cash to pay their AMT from other sources.
To make matters even worse, the stock price fell after that trading window, so their gains went down even more.
Mistake #3: Selling Shares Before They Qualify for Long-Term Capital Gains
When we mention qualified shares, we’re usually talking about exercising and holding ISO for one year so they can qualify for long-term capital gains tax rates.
To be really specific, the holding period to qualify shares for long-term capital gains is one year and one day. Not 365 days, not 360 days, not 355 days… one year PLUS one day.
Every time you exercise ISO and create a lot of shares, it’s crucial to be organized and VERY specific. Write down the date you exercise, and note the date one year and one day later when those shares will qualify.
As you prepare for a trading window and are deciding what to do with your shares, look at which shares DO qualify, and make sure you don’t accidentally sell shares that don’t qualify yet.
If you fail to do this, you could make a mistake costing $100,000 or more in unnecessary taxes. Yeah, not what we want. ????
Mistake #4: A Disqualifying Disposition (DSD) of ISO Shares
Basically, a disqualifying disposition of ISO is when you exercise the shares, and don’t wait long enough for them to qualify for long-term capital gains. (This is two years from the grant date, and one year from the exercise date.)
You might decide to do an exercise and sell on the same day, for example. This is fine, as long as you’re aware of the tax ramifications beforehand.
In 2020, I was working with some clients whose company really benefited from the fact that everyone was working from home, and their stock was going up like crazy.
Because of this, they started to realize they were way outside of what they’d expected as far as stock performance, they didn’t think it was going to last, and they wanted to take their money off the table ASAP.
In this case, the clients were choosing to do a disqualifying disposition of the ISO they’d exercised earlier in the year, or in the year before.
They knew what the tax ramifications would be, but because the stock price was so high, they decided it was worth it.
The reason to watch out for this mistake is because there is no mandatory withholding on the exercise & sell, or on disqualifying dispositions of ISO shares. This means you can quickly add TONS of ordinary income to your tax return with no withholdings to help make up the tax bill.
It’s fine to use this strategy if you find yourself in a position like some of my clients did in 2020, but make sure you’re aware of exactly how much of a tax bill you’ll create when you do it.
Work with your advisor to do the math, set aside money to pay your tax bill, and make an estimated tax payment if needed.
Mistake #5: Not Selling RSU
The final mistake is not selling restricted stock units (RSU).
We’ve covered RSU before a number of times in other posts, and every year, I still have clients going into an IPO, and the only form of equity they have is double-trigger RSU.
Since this is the only equity they have and they think the stock is going to perform well, they get tempted to hold onto it.
Don’t do this. Sell your RSU.
RSUs are always the first thing we sell when we execute a stock option plan. Even if they’re the only form of equity you have, I’ll still probably recommend selling them.
Why?
A few reasons:
1) They’re taxed as ordinary income as soon as they release. You’ll owe taxes on them even if you don’t sell them.
2) If you continue to hold, the value of the shares could go up. This is great, but you don’t get long-term capital gains on 100% of the value: you’ll only get long-term capital gains on the increase in value.
If you have that much faith in your company’s stock, you’d probably be better off to just sell the RSU and use the proceeds to either exercise ISO or buy a bunch of stock on the open market.
3) If you continue to hold, the price can also go down. At that point, 100% of the value of the shares were already taxed on the release date, and there’s no going back to the IRS to tell them that you got taxed on income you can’t even sell anymore. You’ll have to deal with an unrealized capital loss. Even if you do sell the shares, only $3,000 of that capital loss can be used to offset your other sources of income. (It’s not much.)
In short, RSU have the highest possible tax rate, and you’re really limited with what you can do with them in the future; whether for long-term capital gains or for reporting losses to lower your income tax.
Plus, if you don’t sell right away and the value goes down, you can end up in no man’s land:
You’ve got shares that you can’t sell for the value you’ve been taxed on, so year after year you have to decide whether or not the stock will come back or if you should just sell and accept your losses.
It’s only in the last few years, for example, that my clients who worked at Twitter during the IPO have been able to wind down their old RSU positions with big losses. THIS is why it’s always our recommendation to just sell RSU.
Here are some more articles on the complications of RSU, and why it’s better to sell them immediately:
- RSU, Capital Losses, and Wash Sale
- IPO: When to Sell RSU Based on Share Price
- Restricted Stock: The Beginner’s Guide
- Cost Basis & RSU: The Easy-to-Understand Tech Employee’s Guide
IPO Planning Mistakes to Avoid for a More Profitable Future
The whole idea is for you to go into your IPO with a plan you’re comfortable with and confident in.
The five things I’ve mentioned in this article are all fairly easy to avoid, as long as you do your planning in advance with a solid financial planner.
You don’t need to overthink things: you’ve already won by getting this exit, you’re probably in line to make A LOT of money, and hopefully the stock continues to perform well.
But even if it doesn’t perform well, avoiding these five IPO planning mistakes will seriously maximize the value you get from the IPO, minimize your taxes, and avoid costly mistakes.
