So…. your company just announced an IPO.
What WHAAAAT! Time to celebrate! ???? ????
Right?
Well…. truth be told… you haven’t done anything with your stock options yet, so you don’t even know where to start. (And, you maybe feel kinda remorseful that you didn’t have your stuff together before this.)
But honestly, as a financial professional, I understand where you’re coming from:
You probably weren’t sure if your options would even be worth anything, and you didn’t want to use your hard-earned cash to buy shares you couldn’t even sell. (Because who in the world wants to just throw away money?!? ????????♂️)
But now, this IPO changes everything.
Because now you know that if you have shares in the company, you’ll be able to sell them, and they’ll actually be worth something.
The good news is: the stock options you have as a part of your employment agreement are still worth a lot of money, and you can still make the most of it & reap an impressive profit. Even if you went “unprepared” into the IPO with no stock options exercised.
So should you exercise your stock options?
Or sit on your options for a while & wait to see what happens?
In this post, I’m going to walk you through how to go from a bunch of unorganized stock options and not knowing what the heck to do about them… to having a clear, profitable plan you’ll love.
First thing: Get Organized
The first thing you’ll want to do is look at your stock option grant agreements and outline what you have available.
For example, with your stock options, do you have Incentive Stock Options (ISO), or non qualified stock options (NQSO)?
Are they vested or unvested?
If they’re vested, when do they expire? And if they vest, how many will be vested at the IPO, and how many will be vested when the first trading window opens?
And what is the exercise price?
Also, check to see if you’ve got any double-trigger RSU in your grant agreements. How many of them are triggered by the IPO? And how long will you have to wait for the rest of them to vest?
Getting this all down on paper will be a huge step forward.
Review Your Grant Documents
Each employee stock agreement will have grant documents that go along with it. These are the legal documents your company relies on for how your stock options vest and it’s crucial that you read them and understand them. (Yes, even if they’re boring & full of legalese.????)
Thing is, these documents will have really, really important facts in them about when your RSUs will trigger if an IPO happens. (You can usually find this under the “Issuance of Shares” section.)
It also goes over what happens if you change companies, and how long you’ll have to exercise your stock options after you leave.
Consider the Stock Price & Get a Copy of the Trading Calendar
Once you’ve got all that down, it’s time to think about the stock price, and whether or not it makes financial sense to act on different options right away.
For example, do you know what the expected IPO price is?
If so, you can compare it to the value of your vested RSU and stock options to know how much “income” you’ll have at the time of the IPO.
It’s also a good time to think about your desired sell price. At what price would you be comfortable selling your shares at?
Once you know this, take a look at the trading calendar your company has, which will outline all the times in the next year you’ll be able to sell your shares.
You may or may not decide to sell at these different times, but having those time frames in mind will be helpful with your financial planning.
Decide When to Exercise Stock Options: Now or Later?
A lot of people rush to exercise their stock options the instant the IPO is announced. And, it’s understandable. It’s easy to get caught up in the excitement of suddenly having so much money available to you because your company went public and you can now sell your shares.
But before you rush to exercise, it’s important to understand tax and leverage in relation to your stock options… which are two key sources of return.
Leverage: Exercise Stock Options for Cash Later
Leverage is one of the key reasons why not exercising immediately isn’t necessarily a bad thing.
For example, let’s say you have an option to purchase shares at $5 each, and your company’s current fair market value is $50 per share. But even though they’re worth $50, you think they’ll be worth $100 in a year, and I agree with you.
Thing is, if I want to profit on this stock, I have to buy now at $50 for that to happen.
But you don’t.
Your $5 option is there for you, no matter what the market price is. If you want to wait until next year to buy to see if they do go up to $100, you can. And you still get to buy in at $5 each and sell for $100, making a $95 profit per share.
This is the beauty of leverage in stock options. Your cost to exercise is fixed, but your upside is unlimited. Plus, you are not out any cost until you decide to exercise.
Every other investor, without stock options, has to buy now (cost) to get any upside. The longer I wait the higher my cost to purchase (assuming the price continues to rise) and the lower my rate of return.
My rate of return in this example is 100%. I invested $50 to make $50… or 100% of what I initially invested. I had to give up $50 and wait a year to get that original $50 and $50 more back.
Your rate of return, however, is 1,900%, because you invested $5 and made $95. Plus, you got to keep your $5 that year, and still made $95.
Your stock options are powerful and irreplaceable. Think twice about the leverage you give up when you exercise stock options. The moment you exercise you give up leverage, and you lock in cost – the cost to exercise plus the taxes you owe.
Tax
Depending on how you plan for them, taxes can either be a cost or a source of return.
Let’s say you were on top of things, and bought lots of stock option at $5 each long before the IPO when fair market value (FMV) was $5, and you estimated they’d someday be worth $100 each.
In this case, you gave up leverage as a source of return, because shares have no leverage at all, since the FMV was the same as the price you paid.
The beauty here, though, is that all $95 of your profit will be taxed as a long-term capital gain… but if you’d waited to exercise & sell at $100, you’d have kept your leverage, but the $95 would be taxed as ordinary income instead.
So…. can you get the leverage & the tax benefit at the same time now that the IPO’s happened?
So, let’s say the IPO happened, and you decided to buy some shares at the $5 exercise price you have access to.
Whether or not you have leverage and a tax benefit depends on the different types of stock options you hold.
With ISO, you may owe the alternative minimum tax, but with NQSO, you will owe ordinary income tax… based on the difference of their market value and your exercise price.
So let’s say you buy in after the IPO with NQSO, and your normal tax bracket is 35%. This means that, immediately upon buying those shares, you owe $15.75 each in taxes (calculated as $50 FMV minus $5 exercise price times 35%) for each share. ???? (Yeah, I know.)
But let’s take the example a little further, and say you sell those NQSO shares a year later at $100 each. This is a 20% long-term capital gain, so that means $10 in additional tax on each share.
So, your total tax per share after buying and selling is $25.75.
So if you take the $100 you sold each share at, minus the $5 you spent to buy it, and minus the $25.75 in tax you owe on it, that’s a $69.25 profit per share.
And when you look at that percentage-wise, $69.25 divided by the $5 you invested equals 13.85. And made into a percentage, that’s a 1,385% profit. Not too shabby, as long as you’ve got the money to cover the initial taxes.
But… what if you did nothing (no buying, no selling) now and waited a year?
Let’s assume that one year from now, your income tax rate will be 37% instead of the 35% for right now that we assumed with the example above.
$95 gained at 37% = $35.15 in total taxes. With that, your after-tax return would be 1,197%… which is still really good, but not quite as good as acting now. (Essentially, you would have saved $9.40 in taxes by acting now instead of later.)
So, given you’ve got cash to cover the tax cost now, it can be beneficial to act now, and you’re aware of the leverage you’re giving up.
Wrap Your Head Around Taxes & Stock Options
So you’ve clearly already got a lot to think about. ????
And not that I’m trying to over-burden you, but here are a few other things to keep in mind while you make your decisions about what to do now that your company has announced an IPO without you having exercised your stock options.
1. Keep RSUs in Mind
RSUs, or restricted stock units, are likely part of your equity grants and will have an impact on your tax bracket… even if you haven’t done anything with your other stock options until now.
Generally, it’s a good idea to sell these shares as soon as possible, and they’re taxed as ordinary income as soon as they vest. This means there’s not really any opportunity to use taxes as a source of return on your RSUs, and once they’re vested, they don’t give you any leverage.
They’re your best source of immediate cash in an IPO, so if you’re going to sell any of your options as a result of your company going public, sell these first.
2. NonQualified Stock Options
After RSUs, these are the second best source of cash in an IPO… so they should be the second thing you plan to sell after the RSUs.
The important thing, though, is to coordinate your NQSO purchases and sales with your current tax rate…. so it could be beneficial to wait until your tax rate drops, or to wait until the FMV of the stock price goes up and you can get more money from it.
However, exercising and holding onto NQSOs comes at a high tax cost, and leverage is your best source of return with these, not taxes.
3. Incentive Stock Options
These are the most flexible stock options, and definitely give you the best opportunity to get a more profitable outcome with proper planning.
With these, consider how many you can exercise before you trigger the alternative minimum tax. Also, weigh your plans for your ISOs against your plans for your RSUs and NQSOs. Your RSU may increase the number of ISOs you can exercise, for example.
Calculate your break-even price, and then figure out what you’re comfortable with doing from there.
Don’t Worry: An IPO With No Stock Options Exercised is Still a Good Thing
Take a deep breath. And exhale slowly.
Everything is going to be okay, and you can STILL make a lot of money from your company’s IPO, even if you haven’t done anything with your stock options yet.
If you’d like some help planning the smartest moves for profitability both now and in the future, get in touch with us to set up a free conversation on what we can do for you.
And hey… congratulations! ????