Over the last few years, we’ve noticed a BIG trend growing in our clients who work for startups: The opportunity for selling early employee equity before the IPO.
In the past, startup companies would go from zero to IPO in just a few years, but now lots of companies are taking ten years or more to get there. This makes things interesting (to say the least) for their employees and what it means for how they can use their equity compensation.
This later-than-usual IPO trend is partly due to alllll the venture capital available to fund growth, so IPOs aren’t necessarily needed for a company to reach their next level of success. (But, even though the IPO doesn’t happen, it does still give founders and early employees the opportunity to liquidate their stock so they can have the cash to advance other financial goals.)
These events are usually called tender offers or secondary offerings, and they’re typically tied to fundraising rounds.
Selling Early Employee Equity is Different From Selling Founders Shares
When you’re a founder, you almost always have shares that were distributed when the company started, which are often referred to as founder’s shares.
In some ways, founder’s shares are easier to deal with because you’ve got fewer decisions to make than if you’re dealing with stock options, which is what most early employee equity consists of. (Once you have shares, you pretty much just have to decide if and when to sell.)
But when you’ve got stock options instead of shares, you have more decisions to make.
Selling these stock options before the IPO is a HUGE opportunity to advance your financial plan… but you’ve got a lot more to think about than your founders do.
Beyond just selling, you’ll have to think about what and when to exercise, taxes on what you exercise, your holding periods for long-term capital gains or QSBS (qualified small business stock), cost basis, timing of the sale, and taxes on the sale. ????
You’ve got a lot of choices to make, but just because there’s a lot of math to do doesn’t mean you shouldn’t act.
Don’t Pass Up the Opportunity to Sell Early Employee Equity
If you get the opportunity to liquidate some of your stock options as an early employee, don’t pass it up. Here are four steps to help you make the most of it:
Step 1: Review your Stock Option Grant
If this is an early opportunity, like Series C round funding, you may only have the one grant of stock options you got when you started working for the company. Look at the details of that grant to see if you’ve got all ISO (incentive stock options), or if you have a split of ISO and NSO (non-qualified stock options).
If you do have a split, it usually comes from the $100,000 rule, which says that no more than $100,000 worth of ISO based on value at grant can vest in any one year. Sometimes, as an early employee, your cost to exercise is so low that the $100,000 rule won’t ever become an issue… but it’s good to be aware of it anyway.
Then, while you’re looking over your grant, see how much you’ve exercised already. How much of that grant has already been exercised? How much of it do you have left?
Step 2: Set Your Goals
What are you hoping to accomplish by liquidating some of your equity?
Do you want to exercise and hold more to increase your wealth later?
Do you want to liquidate some cash for another financial goal? (Like buying a house or paying off student loan?)
The participation in a tender offer in and of itself isn’t a goal: how do you want your participation in this offer to further your long-term financial plans?
Step 3: Check the Offer
Now that you know what your goals are with selling, it’s time to decide if you actually *want* to sell.
What is the price the offer allows you to sell at?
Do you like this price, given the current position of the company and your financial goals?
What percentage does the offer allow you to sell?
Often, in tender offers or secondary offerings, you’ll only be allowed to sell a percentage of your options. Often, we see anywhere from 10% to 25% of your options allowed to sell.
Just because you can sell doesn’t mean you should, or that you’ll even want to.
In past blog posts I’ve written, I talk a lot about how the selling price is one of the most important factors in a successful stock option plan. Honestly, price matters more than almost anything else. (The amount of shares and options you have is the second most important factor.)
For example, choosing to exercise and hold is a common strategy to lower long-term tax bills. But when you sell now & reduce the number of options available to you in a future, more profitable event, you may actually cost yourself more money than you’d save in taxes by exercising now.
This is why it’s so important to be clear about what you’re doing and to work with a professional financial advisor, especially one who specializes in helping tech and startup employees like you.
Step 4: Make the Election
After you’ve done all the math, decide what percentage you’ll sell during this event, and from that, decide between shares or options.
If the goal is to create cash for another financial goal, you may want to sell shares to minimize tax and maximize the cash you’ll get out of the deal. But if your goal is to just create more long-term wealth in the big picture, you might choose to exercise and hold.
What to do After the Offer Closes (Your Work Isn’t Done Yet)
The first thing to take care of after you sell shares or exercise options is calculating and paying with taxes.
So fun, I know. ????
First, we’ll calculate the taxes you’ll owe as a result of this event (in addition to whatever you’re paying for your regular income tax). To do this, we’ll need three documents:
- Transaction confirmation
- Pay stub after the offer
- Most recent tax return
We’ll use these documents to figure out what your taxes should be, and it’s helpful to work with a professional when doing this, because there are A LOT of moving pieces to calculate. (Back-of-the-envelope math almost never cuts it.)
Sometimes, we’ll realize you need to make an estimated tax payment to avoid an underpayment penalty, and we’ll have you send that in. (Just for reference: to avoid this penalty, you’ll need to pre-pay the lesser of 100% of last year’s tax bill, or 90% of this year’s tax bill.)
We’ll also make sure you won’t face an underpayment penalty for your state taxes, because those rules can be different depending on where you live. In California, for example, when your income goes over $1 million, you have to pay 90% of the current years’ tax.
Next: Work on Your Financial Goals
If your goal with participating in this event was to fund other financial goals, you’ll still want to take care of your taxes first.
But after your taxes are taken care of, you can use the remaining cash to fund whatever your goal was. If it was to buy a house or pay off debt, do that.
If the goal was to use the cash to then exercise more options, you and your financial advisor have some more math to do. You’ll need to figure out how many more to exercise now, next year, and how you’ll time next years’ exercise for January.
Selling Early Employee Equity: A Case Study
Our client Eric was one of the first employees hired by his startup: he was a single taxpayer with a $200,000 per year salary, and taking the standard deduction. When he was first hired four years ago, he was granted 350,000 ISO at a $1 per share exercise price.
His founders decided to go through a Series C round of funding, and gave their employees the opportunity to sell up to 15% of their vested equity at $5 per share. For Eric, this meant he had 52,500 total shares he could sell if he wanted to.
To date, he hadn’t exercised any stock options and didn’t really have any other immediate goals to fund… so he didn’t have any other cash needs.
On the other hand, he also didn’t have a lot of extra cash on-hand to self-fund the exercise of his options.
So… how did we help Eric make the most of this opportunity?
First, we evaluated the opportunity in front of him.
Eric’s potential AMT exposure equated to $1,400,000. (We get this by: $5 FMV – $1 exercise price x 350,000 = total bargain element.)
So based on his salary alone, he can recognize $30,000 of ISO bargain element without AMT.
If he exercised all of his options, then he’d trigger a $402,994 tax bill in *just* AMT for the federal government. States like California sometimes have their own version of AMT, so it could potentially be even more expensive.
With this high of an AMT, it’d be super expensive for Eric to just exercise and hold. Because of this, we decided to help Eric exercise and sell… and then use his cash from the sale to exercise his other options.
Second, we executed on the offer.
After talking with Eric and reviewing his financial situation, we recommended that he participate in the tender offer at the full 15% so he could get cat to exercise and hold more shares, that will likely qualify for long-term capital gains tax by the time he sells them.
Even after he sells 15% of his options, he’ll still have 85% of his grant available to work with, and participating in the tender offer increases the bargain element he can recognize without AMT from $30,000 to $85,000. (If you break this down into ISO, that’s 21,250 exercised vs just 7,500… which is almost triple the amount he could exercise by participating in the tender offer.)
By selling the 15% now, he’ll have cash to exercise and hold… and create shares that will qualify for long-term capital gains tax… and maybe even qualified small business shares, which would be incredible.
Third, we paid his taxes.
After selling 52,500 ISO at $5 each, Eric had $210,000 in gross cash to work with.
He owed $72,902 in federal tax from the exercise, and we made an estimated tax payment based on that. (Also note: it’s very important to watch out for state taxes as well, which will vary depending on where you live. Work with a financial advisor to figure out what yours will be.)
Fourth, we exercised his ISO.
After tax , Eric was left with $137,093 net cash.
With his AMT bargain element, we exercised 21,250 ISO immediately, which cost him $21,250.
Once this was finished, he had a sum of $115,843 cash left over, so we made a plan on when to exercise next to make the most of his cash and pay less in taxes.
If you find yourself in a situation like Eric’s and it’s in the first six months of the year, go ahead and exercise more ISO now, knowing that you’ll owe AMT next April.
For Eric, we would have exercised 49,000 more ISO at a $49,000 cost, which would equate to a $66,843 federal tax bill, bringing him down to $0 cash remaining.
Out of his initial 350,000 ISO, he would have exercised and sold 52,500, and exercised and held a total of 70,250. He would have 227,250 ISO left to work with in the future.
But if you’re in the second half of the year and you don’t expect the FMB to increase, it’s best to wait and exercise in January.
If this were Eric’s situation, we’d have him exercise 59,000 ISO in January, with a $59,000 exercise cost.
This would generate a $56,843 federal AMT bill, leaving him with $0 cash remaining.
In this scenario, he’d have exercised and sold 52,500, and exercised and held a total of 80,250, and would have 217,250 ISO left to work with in the future. (In this case, he would have 10,000 more shares available that could qualify for long-term capital gains or QSBS tax qualifications, which puts him in a better position financially.)
Plus, the AMT wouldn’t have to be paid for 12-16 months, which gives him a little more wiggle room if he decides to sell any of his shares before the tax bill is due.
Conclusion: In Short: Sell Your Equity if It Makes Sense
Not every tender offer will be a good one, but if you’ve got immediate financial goals to take care of now, liquidating your early employee equity is a fantastic way to fund them that doesn’t cut into your day-to-day budget.
It can also be a great way to experiment with the exercise and hold strategy, since you’re limited on how much you can exercise… and therefore won’t be tempted to “risk it all” in one big financial event.