If you are currently working at a large private company you may often hear rumors about the inevitability of an IPO in the near future. These rumors can be difficult to decode; for example, Airbnb has been rumored for an IPO since 2013. With companies now staying private for longer, the delay can be frustrating for employees who have stock options that are awaiting a liquidity event.
What that being said, it is never too early to start planning for the possibility of an IPO.
The question that we – as equity and tax advisors- hear most often is something along the lines of, “Should I exercise my stock options prior to IPO?”The answer is (as with anything financially related): it depends. However, if you were to exercise your stock options prior to an IPO, the primary benefit would be found in the potential tax savings that accompany this decision.
On the date you exercise your stock options, the clock starts the 12-month countdown to the highly favorable long-term capital gains tax rate.* The earlier you start this clock, the earlier you will be able to actually sell your shares on favorable tax terms. The idea is that you generally want the ability to sell your shares on favorable terms sooner than later so you can respond to market events without inheriting a massive tax bill.
*The shares must be held for 12 months after exercising and 2 years after grant in order to qualify for long-term capital gains tax rate.
For example, if and when your company goes IPO, your shares will be subject to a 180-day lockup period in which you will be unable to sell them. The idea behind this lockup is to minimize volatility and allow the market to decide upon a fair valuation of the shares. You will be subject to this 180-day period regardless of when you exercise your options; no employee can sell their shares during this period.
It can be very frustrating to watch the share price swing across dramatic highs and lows during this 180-day lockup period. For example, when Twitter went IPO the share price started around $40,reached a high of around $70, and then settled around $30 — all within six months.
If you had not exercised your options prior to the IPO, you would be in a position where you would likely need to wait at least an additional six months – beyond the end of the lock-up period – before you would have held your shares long enough to qualify for the long-term capital gains tax. This means six more months of volatile stock prices and all the associated stress.
However, if you had exercised your options prior to the IPO then you could be eligible to sell your shares at a favorable tax rate as soon as the 180-day lockup period expires (of course, this depends on how far previous to the IPO you exercised your options). This isn’t to say that you would necessarily sell your shares at that point,though you would likely benefit from having the freedom to control what you do with your shares without worrying about the tax consequences.
In exchange for the ability to have more immediate control over disposing of your shares at a favorable tax rate, there are some risks and costs that should be considered.
First, there is always the risk that the share price will fall below your exercise price. If this were to happen, you would be in a position where you essentially “overpaid” for the shares by exercising early.
Secondly, there is the consideration of AMT (Alternative Minimum Tax). When you exercise your stock options (assuming they are incentive stock options or ISOs), you will owe an AMT preference that could be equal to roughly 28% of the amount of the spread between your strike price (what you paid to buy the shares) and the fair market value on the day you exercised. Depending on the timing of the IPO and the possibility of a delay, you may find yourself in a situation where you owe AMT but you don’t have the ability to sell your shares yet (due to the 180-day lockup). If this happens, you will need to come up with another way to pay the IRS without selling your shares, and for most people this can be very difficult.
The key takeaway when considering whether to sell early is that it really depends on your personal financial situation. At Vestboard, we have a team of CPAs and equity advisors who are able to assess your situation and provide an expert opinion on the best way to proceed.
Disclaimer: This article is intended as general information only and should not be interpreted as investment or tax advice. Vestboard makes no guarantees as to the accuracy, completeness, suitability, or validity of any information contained on this site. Each individual has their own unique circumstances which must be taken into consideration. Financial advice is only granted to individuals who become Vestboard clients. Past performance does not guarantee future results.