Last month, we talked about the risk factors of the five types of equity available to employees in a private / pre-IPO company.
As a review, those five things are:
- Qualified small business stock
- Long-term capital gains shares
- Unexercised ISO
- Unexercised NSO
- Restricted Stock Units (RSU)
Each one carries its own unique cost, investment, and career risk… but all are great potential sources of income beyond your salary.
But today I want to take it a step further and talk about something really juicy: two ADDITIONAL sources of return when exercising stock options in a private company.
But First, A Side Note: Price is What Wins. Always. Strategies like this are just a fun little bonus.
If and when your company has a successful exit… either by selling to another company or going through an IPO, you being able to sell your shares at a good price is what matters more than anything.
The financial planning and details we’ll talk about in this post are just details that can take you from earning a lot of money in a successful exit to making more of a lot of money. (Think of it like chocolate sprinkles on top of an already-delicious ice cream sundae.????)
There is no such thing as the “perfect financial plan” that will make you rich beyond your wildest dreams. Yes, you can be made rich beyond your wildest dreams… but the price you sell at is what determines that more than financial projections or tax planning.
Of course, it never hurts to understand the things that can give you those metaphorical chocolate sprinkles on top of the delicious sundae of wealth you can get via exercising stock options in a private company. And those two sources of additional return we’ll talk about today are leverage and taxes.
Leverage as a Source of Additional Return When Exercising Stock Options in a Private Company
“Leverage” is a term that gets thrown around the financial world a lot, but what is it exactly?
For a lot of people, it helps to think of leverage in terms of buying a house. ????
Let’s say you buy a house for $1,000,000, and you put down a $200,000 down payment. Assuming a 5% growth in home value each year, your house is worth $1,050,000 one year later. And while that’s only a 5% rate of return in your home value, it’s a 25% rate of return on the money you put down. (Only $200,000 of the total $1,000,000 value.)
With that, one year after you put down the $200,000, that equity is now worth $250,000. Or, 25% more than what you invested. ???? Your cost of the mortgage is fixed, but you get to keep all of the appreciation value that happens to the house over time.
Make sense?
So, as an employee in a private company, you can also use leverage as a source of return with your stock options.
Let’s pretend you work for a company that goes through an IPO, and I don’t work there, but I want to invest.
At the IPO, I spend $50 per share and sell those shares a year later for $100. My rate of return is 100% because I put in $50 and got an additional $50 back.
But, if you’ve got access to NSO within that company at a $5 strike price, you don’t even have to spend any money when I buy my shares.
The same day that I sell the shares I bought for $50 each a year ago, you can decide to exercise your $5 strike price and sell those same shares for $100.
I get a 100% return on my investment, which is pretty good, but you get a 1,900% return on your investment, which is even better. ???? (You bought for $5 and sold for $100, making $95 on each share.)
Like a mortgage on a house, your cost is fixed because you can always buy in at $5. And also like a house, you get to keep any and all appreciation in value that happens.
Why Leverage Gets Overlooked as a Source of Return
Leverage like this is an incredible benefit, but it gets overlooked. Usually, employees are sucked into thinking about the taxes they’ll owe when they exercise, that they don’t look at the whole picture.
But let me ask you: if you could get a 1,900% return on your investment, would you really be sweating the difference of the taxes you’d owe at that point?
This kind of leverage was overlooked by employees of both Uber and WeWork.
At Uber, employees wanted to exercise their NSO and pay ordinary income tax at $40 FMV (fair market value) because they thought they could sell at $80 once the IPO happened. Unfortunately, Uber’s been trading below $40 for the last three months. ????
When WeWork’s IPO was announced, I talked to a lot of employees who wanted to exercise their NSO to pay ordinary income tax on what they thought was a low FMV based on the IPO projections WeWork talked about.
Push came to shove with WeWork, and they actually cancelled their IPO, leaving the people who decided to exercise their NSO out of luck.
In both cases, though, people were rushing to exercise their NSO because they were discounting the potential for leverage in comparison to the tax “advantage” of long-term capital gains tax, which turned out to not be an advantage at all here, because of what happened to the market price of those shares.
(Remember how I said price was the most important thing earlier in the article? THIS is why. ????)
Taxes as a Source of Return
I know, I know. It sounds like some kind of voodoo magic when I say taxes (the things that take money out of your pocket) can actually be a source of return for you. ???? But they can be.
The thing is, when you’re aware of tax laws and do smart financial planning, you can actually reduce the number of dollars you pay in taxes and increase the number of dollars that get to stay in your bank account. ????
You use your tax return to do this, and there are two main things you can do now to make sure taxes are a source of return for you:
- Exercise ASAP
- Tax Rate Arbitrage
Exercising Your Private Company Stock Options ASAP
The sooner you exercise, the more likely your exercise amount and the FMV will be close to the same price. This is most likely early in your vesting schedule.
If it’s possible, exercise at the time your options are granted and file an 83(b) election. (Basically, this means that you gain “ownership” of the shares when they’re granted, not necessarily when they vest. It also means that you pre-pay your taxes on the current market value, not the value of when they vest, which could be much higher. This can save you a lot of money in taxes over the long run.)
Exercising ASAP also puts time in your favor… especially if you exercise in January.
To qualify for long-term capital gains, you only have to hold your shares for 12 months. But if you exercise in January, you get a 15-month period between the time of exercise and the time when the taxes are due. (This means you can buy, sell, and have money to pay any taxes owed on the exercise.)
Tax Rate Arbitrage
This strategy of using taxes as a source of return is about timing your transactions to take advantage of the different tax rates depending on the year, your income, and how much you’ll owe.
When it comes to income tax, there are seven different federal brackets you can fall into. For investments, there are three different tax brackets for long-term capital gains. Knowing which brackets you’ll fall into each year is important, because it means you can delay or speed up your planned transaction to avoid paying tax in a higher bracket.
For example, if you’re on the cusp of the 24% and 32% income tax brackets, that’s a difference of $8 on every $100 you make from a short-term investment you’d pay ordinary income tax on. Knowing where you fall will either help you stay within the 24% range for the year, or let you know how much more the price needs to increase before you sell a stock option to make up that $8 difference.
There’s a lot of math involved in this, but it really can make a difference on the amount of money you get to keep after tax.
Exercising Stock Options in a Private Company: Start Planning Now
Even if your company’s IPO isn’t anywhere on the horizon yet, it never hurts to have a solid plan in place.
Exercising stock options in a private company, especially a company you believe will make it big, can be an incredible investment. It might not be a plan you take massive action on now, but knowing what to do when will keep you level-headed when big things start to happen in an IPO, and help make sure you get the most out of the money you invest.
Our office specializes in this kind of planning, particularly with startup companies and employees with stock options packages. We excel at making the most of any financial situation, and can review your stock options benefits to set you up for an incredible financial future.