It’s great when a company gives you stock options. It’s even better when those stock options give you massive pay day when the company goes public. What’s not great is that to exercise these stock options, you have to spend money. Money that may not ever pay you back very well, or that you might lose forever. This is why recycling ISO in a employee tender offer is such a great idea. It lets you sell the stock options you have and get shares without putting any of your cash on the line.
It doesn’t cost you any more money, but you get some great tax advantages and you could lower your future taxes, making that potential IPO payoff even bigger.
Here’s how you do it:
Recycling ISO in an Employee Tender Offer – What Does It Mean?
First off, let’s make sure we’re all on the same page about what I mean when I talk about recycling stock options.
Basically, recycling your stock options means selling some of the stock options you already have, and then using that cash to exercise more shares to hold until you can sell them again in the future.
In most employee tender offers, you’ll be able to sell shares at a price higher than what it costs you to buy, so this puts you at a huge advantage. You’ll have the money you need to pay taxes on the sale of your shares, and the ability to exercise more shares than you had before with the leftover cash.
This eliminates the cost risk of investing in private company stock options. Normally, when you invest money in non-liquid stocks that can’t be sold on the stock market, that money essentially disappears until the day the company goes public. But since you aren’t using your own money to make this investment, the risk is lower.
Note: this recycling procedure doesn’t necessarily have to be in a tender offer. You can also do it after an IPO, but doing it during a tender offer lets you:
- Exercise & hold most of your stock options by selling some now
- Avoid the golden handcuffs that come with unexercised stock options that you lose if you leave the company
- Have more shares taxed as long-term capital gain in a future IPO… instead of waiting to buy shares when an IPO is imminent, and holding them for less than a year before you sell, making the taxes higher.
7 Steps to Recycle Stock Options in an Employee Tender Offer
The way you recycle stock options in a tender offer is pretty straight forward:
1. Organize the Stock Options You Have Available
First, organize all your stock options grants by the type of options you have available. (Typically these are Incentive Stock Options ISO and Nonqualified Stock Options NQSO.)
Then, list out the exercise price for each, as well as the number of shares for each that you already have vested. This will give you a clear picture of your starting point.
2. Calculate the Total Cost to Exercise
Before you make any moves in selling old shares or buying new ones, figure out how much money the actual exercise will cost you.
How many do you want to buy? And what’s the cost to buy each one? Multiply the number of options you want to purchase by the cost for each. Do this for both ISO and NQSO.
3. Estimate a Tax Projection
To estimate your taxes, use your current pay stub and your last tax return.
First, create a tax projection based on your current scenario. How much will you owe if you do nothing with this tender offer for shares and just keep everything as-is?
Take a look at which tax bracket you’re in, how much additional income you need to move into the next tax bracket, and how many ISO you can exercise before you trigger the AMT. (A lot of this math can get pretty complicated, so it’s usually best to work with a tax professional on this. You can book a call with one of our team members here.)
4. Figure Out How Many Shares You Need to Sell
Using your tax projection as a starting point, remember this:
The ultimate goal is to sell as few of your stock options as possible while exercising as many remaining stock options as you can. This will affect which stock options (ISO or NQSO) you decide to sell, and involves two main considerations:
One, you’ll ideally sell your nonqualified stock options first. These are taxed at ordinary income upon exercise. (Essentially there’s zero reason or tax benefit to hold onto these longer than a day, given you have an option to sell.)
Two, after you exercise and sell the NQSO you have available, you’ll want to exercise and hold your ISO, or incentive stock options. You’re looking to break even from net proceeds from the sale with the total cost of your exercise and hold, plus tax costs.
It’s a complex calculation, but when done right, no additional money has to leave your bank account. If you’re not seasoned in running this type of calculation, a lot of things can come up that might throw you off base. It’s best to work with a professional, and my team and I have probably done more of these calculations than we’ve drank cups of coffee.
5. Execute the Sell
Sell your shares.
Once get your cash in hand, update your tax projection. (What you figured out in step 3.) More than likely, your income from the tender offer will appear on your pay stub, so you can use your pay stub to more accurately update the taxes you’ll owe in the spring.
6. Make a Tax Payment
You can either pay the taxes now or in April, but if you don’t pay at the right time, you could face a penalty. Talk to a financial planner to figure out the best course of action, and whether or not you’ll be penalized for underpayment if the tax estimates your employer takes out aren’t enough.
If an underpayment penalty might be on the table, go ahead and send in an estimated payment now. If not, there’s nothing wrong with waiting until April to pay… just make sure you set the money aside so you don’t come up short-handed later.
If you’re unsure, there’s never anything wrong with paying your taxes in advance, so go ahead and send in the estimated payment.
7. Exercise & Hold Your Remaining Stock Options
With the money you have available, exercise your Incentive Stock Options (ISO) and hold them. I wouldn’t recommend buying more NQSO right now, because like I mentioned above, these stock options are taxed at the ordinary income rate the moment you exercise… and you have no idea how long it will be before you’re allowed to sell again. ISO, on the other hand, qualify for being taxed as long-term capital gains if you hold them for more than a year.
Also, use the AMT wiggle room you figured out in step 3 as your guide for how much to buy. If you go over this threshold, you’ll owe tax on AMT, and that’s not a fun position to be in.
The good news is that if you do trigger the AMT, the increased income from selling your stock options will help you out. It’ll likely decrease what you owe… so if you have big goals of exercising a lot of stock options, it’s still best to buy them in the same year you sell options in the tender offer. This way, even if the AMT gets triggered, you won’t owe quite as much. (Read the case study below to see just how much it can help.)
Case Study: Recycling Stock Options in a Tender Offer
One of our clients works for a private tech company, and was granted a total of 250,000 stock options. She had 150,000 ISO and 100,000 NQSO. The company hadn’t announced a tender offer or IPO, but she decided she wanted to exercise her options because the market value was already 4x her cost to buy in. So, earlier this year, she exercised and held all her vested ISO.
The total cost was $300,000, which included the cost to exercise and pay the AMT.
But now, in the same calendar year, the company announced a tender offer at 11x her exercise price. At first, she thought she should just do nothing.
But after looking at her pay stub and updating her tax projection, we decided to run some numbers on what would happen if she sold some of her NQSO. We found that as we exercised more NQSO, her ordinary income amount would go up, and we’d reduce the amount of AMT she owed from earlier in the year. Plus, since the tender offer was at 11x her cost, she could afford to sell fewer NQSO and still bring in a significant amount of cash.
She sold 20,000 of her NQSO in the tender offer, and it slashed her total cost from her ISO exercise earlier in the year by $185,000. Here’s how:
In her NQSO sale, she got $200,000 cash, which only increased her total taxes owed by $15,000.
So, her $300,000 initial cost minus the $200,000 cash from the tender offer equals $100,000. Then, add on the additional $15,000 tax, and you’ve got a total cost of just $115,000, which is $185,000 LESS than her total cost before. The total cost went down by 62%, and her total stock options went down by only 8%. (After selling 20,000 NQSO, she now has 230,000 instead of 250,000.)
Seems pretty magical, right?
It is.
Make Your Own Money Magic by Recycling Stocks in an Employee Tender Offer
And we can help you figure out how to do things like this too. Book a call with me today, and we’ll talk about how to make the most of your tender offer and available stock options in your pre-IPO company.
