Are You Prepared for Your Company’s IPO?

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You own stock or stock options in a private company that has just announced plans to go public. What now?

financial planning around an ipo

By Clayton Boone, CFA, CFP® and Matt Mormino, CFP®

Your company’s IPO can be a really exciting time if you own stock or stock options. With good planning and a little luck, IPOs can supercharge your financial future.

Stocks and stock options are also complicated, especially if it’s your first IPO rodeo. There are strict terms, different strategies, and a lot of tax implications that can impact your entire financial profile. This article is a primer on how IPOs work, and what you can do to get ready for yours.

NEW: The Complete Guide to Financial Planning After Your Company’s IPO

IPOs at a Glance

An IPO, or “initial public offering,” is the first step to becoming a publicly traded company. It’s a way to help a company raise funds, grow its reputation, and (most appealingly to employees like you) provide liquidity to existing owners.

Employees get to take advantage of their company’s IPO if they either own shares of stock (like RSUs) or stock options (ISOs or NSOs). We’ll walk through some differences between stock units and options in a bit, but generally speaking, employees will have to make a couple of decisions: if and when to exercise their options, and if and when to sell their shares.

Both exercising and selling will impact your earned income and your tax rates—that’s why working with a financial advisor is so helpful. They can help you plot out a long-term strategy that takes into account the full breadth of your financial goals, maximizes the value of your stock ownership, and minimizes your risk.

Key IPO Terms to Remember

  • Lockup period: The length of time (often 90 or 180 days) following an IPO during which employees and insiders cannot sell their stock. This helps protect a company’s stock value in its early days on the market. If every employee immediately sold their stock, the downside pressure would give investors a terrible impression and harm the company’s future growth potential.
  • Vesting schedule: The timeline that dictates when employees can exercise and sell their stock options and shares. We’ve discussed vesting schedules in-depth before.
  • Exercise: When you exercise your stock options, you’re purchasing those shares at the strike price outlined in your contract, regardless of their price at the time. Once you exercise your options, you have the opportunity to sell them to the public.

How to Get Ready for Your Company’s IPO

Before the IPO: Carefully review any option or grant documents, and confirm how your company has structured your options, units, or shares. Your organization’s finance or HR team are good resources for this information.

You want to make sure you understand if the company is making any organizational changes as a result of the IPO that may impact the price, number of shares, or timing of the vesting schedule.

For example, stock splits and reverse stock splits are not uncommon at private companies preparing to IPO. Stock splits are a strategy that an organization can use to increase the total number of available shares while lowering the price—essentially cutting more slices out of the same size pie. If you own one share/slice that is worth $100 and your company employs a 2:1 split, you now own two shares/slices each worth $50. Reverse stock splits are, you guessed it, the reverse.

During the lockup period: Sit tight and don’t “pre-spend,” even if it looks like your stocks will be worth a lot. Trust us, we know it can be extremely tempting to operate as though you’ll pay yourself back with the cash you’ll make once you sell your shares. But hold off on any big purchases. A lot can happen in the weeks between an IPO and when you’re free to enter the rink.

Instead, use this time to monitor your company’s market activity, speak to an accountant or financial advisor to understand your different tax scenarios, and develop a game plan.

After the lockup period: Like we mentioned earlier, there are a few strategic moves you can make at this point in the IPO. You are free to exercise any vested options and sell any vested shares. Diversifying your holdings could be a financially powerful move, especially if you have a considerable amount of shares tied up in your employer.

Let’s explore the most common type of stock assets and how you might approach exercising and selling.

Should You Exercise Your Options? Should You Sell Your Shares?

These are the two main decisions you’ll need to make once your company goes public. Both come with tax implications attached. We’ll walk through some examples of those in a moment.
First, a quick reminder on the most common types of options and shares employees have access to:

  • ISOs, or incentive stock options, allow you to purchase shares in the company, usually at a discounted price compared to fair market value. ISOs are especially great because, if executed properly, they are subject to capital gains taxes, not income taxes. To qualify, shares must be exercised and held at least one year after vesting and at least two years after the grant date. Read more about ISOs (and their tag-along companion, alternative minimum tax).
  • NSOs, or non-qualified stock options, are generally granted to non-employees, but can also be offered to employees and contractors once companies reach a specific size and can no longer offer ISOs. You pay taxes on the spread between the grant and exercise prices, which means income taxes must be paid at the time of exercise. Learn more about ISO vs. NSO taxation.
  • RSUs, or restricted stock units, are shares (as opposed to options) given to an employee as compensation, often on some sort of vesting schedule. They have no value until they are vested, after which they are transferred to you. Generally, RSUs are taxed at the same time they are transferred.

Deciding if and when to exercise and/or sell your options and shares is easiest when you and your financial advisor take a holistic view of your tax scenarios, projected value, and financial objectives.

Remember, you don’t have to exercise options or sell shares the moment the lockup period is complete—you have all the way until their expiration date. Generally, though, the goal is to exercise them when they are worth the least on the public market to minimize the amount you’ll pay income tax on, as opposed to the more beneficial capital gains tax rate.

An example might help.

Imagine this: Your company is going public next month at an expected value of $20/share. You were granted an ISO to purchase 2,000 shares at $10 each, which have fully vested. Their expiration date is in three years, and you’re planning to pay for your kid’s college tuition in five years.

Exercising immediately means you’ll only pay income tax on $20,000 of earnings—you paid $20,000 for 2,000 shares worth $40,000. If you wait for, say, three years until your options are about to expire, and the value of each share increases over that time, your earned income will also go up, along with your taxes.

There are some pretty obvious assumptions here, right? The value of a share doesn’t necessarily increase over time. That’s why we said at the very beginning of this article, wealth generation through company stock requires planning and some luck. A good financial advisor will be able to help you evaluate what your options might be worth moving forward.

Let’s look at how the numbers for these scenarios play out if you were to sell all your shares in year five to help fund your kid’s tuition. We’ll assume the value of the shares steadily increases during that time.

Exercise immediately, hold 4 years, then sell at year 5 Wait to exercise 3 years, hold 2 years, then sell at year 5
Your strike price $10/share $10/share
Stock price at exercise $20/share Increased to $30/share
Total value of shares $40,000 $60,000
You pay  $20,000 $20,000
Your earned income (on paper) $20,000 $40,000
Stock price in year 5 Increased to $40/share Increased to $40/share
Total proceeds upon sale $80,000 $80,000
Realized gains
(proceeds minus earned income), taxed at beneficial capital gains rate
$60,000 $40,000

In this example, exercising immediately was the more strategic decision. Which isn’t to say holding off on exercising was a bad idea. Maybe you held off so you could invest in a more urgent opportunity. Maybe you needed the extra three years to save up cash to purchase the options with a cash exercise (as opposed to a cashless exercise, where you immediately sell the required number of shares to cover the cost to exercise).

Working with a tax professional experienced with stock-based compensation and IPOs makes navigating the nuances and complexities of these scenarios a lot less daunting.

NEW: The Complete Guide to Financial Planning After Your Company’s IPO

Clayton Boone, CFA, CFP® and Matt Mormino, CFP® serve as advisors at Brighton Jones.

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