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Now that you know what to expect throughout the IPO process and an overview of costly mistakes to avoid, this post is going to focus on what strategies to consider leading up to & after an IPO. If you haven’t checked out Part 1 – We’re Going Public! or Part 2 – Mistakes to Avoid, then I would suggest checking them out as they will provide valuable context for this post.

When it comes to equity planning, a lot of people think an advisor’s role is to help them “optimize their equity”, and I would agree with this. Most people would interpret this to mean, “help minimize my taxes” and “help maximize my equity value”. However, I believe it’s worth asking the question, “what do you want to optimize for?”

  • Is it to use your equity to build your dream home?
  • Do you desire to secure your children’s education with a lump-sum funding to their 529 plan?
  • Could your equity proceeds create the opportunity for you to be “work optional”?
  • What is the maximum amount you could exercise before triggering AMT?
  • What sales strategy will allow you to accelerate the recovery of AMT credits?

You see? Equity decisions are not black & white. Depending on what you want to optimize for influences how you proceed with making equity decisions. I’ve worked with multiple individuals at the same company and my advice has been different because they each have their own unique situation & personal goals. That’s why I believe it’s so important to create an equity plan that optimizes for your personal objectives.

So now that you know where I’m coming from, let’s dive into some planning opportunities.

Incentive Stock Options (ISOs)

This is the most nuanced form of equity and yet ISOs also provide the most valuable planning opportunities, IMO. ISOs are typically granted to employees who joined the company early in the company’s journey, therefore, their exercise price, or the cost to purchase shares in their company could be very low relative to what the company’s stock price is today. The lower your exercise price, the more valuable proactive planning becomes.

One of the primary factors to be aware of before  you “exercise” (i.e. buy shares) your ISOs is the company’s Fair Market Value, also known as the 409a price for private companies. The larger the spread between the company’s current FMV and your exercise price, the more likely that you could incur taxes upon exercising. The type of tax that results from exercising an ISO is known as Alternative Minimum Tax, or AMT. Some of you may have heard horror stories about AMT from colleagues or maybe even had a surprise AMT bill yourself in the past. AMT is not a dealbreaker that should prevent you from exercising your ISOs, however, you want to understand on the front end 1) how much AMT you would incur by exercising your ISOs and 2) when this AMT is due. Your company, nor will Carta or Shareworks, withhold taxes when you exercise ISOs. AMT is your responsibility to pay and you may need to pay a portion of this tax before you file your tax return to avoid penalties.

Once you identify how much exposure you have to AMT, then you need to understand the risks and potential rewards associated with exercising ISOs and evaluate the sources of funds available to help cover your exercise costs and AMT.

Planning Corner with ISOs:

  • Valuation Discounts for Private Companies – While your company is still private, the 409a price is often discounted relative to the Fair Market Value when the stock is listed on a public stock exchange. This is because there is an “illiquidity discount” applied on the valuation while the company is private. Additionally, the 409a price is valuing the price of “common” stock vs. “preferred” stock that investors purchase.
  • Annual AMT Exemption – Each year there is an opportunity to exercise some ISOs without paying AMT. The larger the spread between your company’s current FMV and your exercise price, the lower the “tax-free” threshold for exercising ISOs. However, this is a “use it or lose it” opportunity, so taking advantage of this over multiple years can allow you to acquire shares without the tax burden.
  • Exercise Timing for Enhanced Flexibility – While I don’t believe in trying to time most investment decisions, exercising ISOs is one investment decision where you can benefit from optimal timing. Early in the calendar year is considered the ideal time to exercise ISOs for two primary reasons. 1) If you exercise your ISOs in January – March, you have the ability to hold these for the next 12 months and would be positioned to then sell the shares as a “qualifying disposition”, which would allow you to receive the favorable long-term capital gains treatment on the sale. The qualifying sale could occur before the April 15th tax deadline, therefore you could use the sale proceeds to cover any remaining AMT liabilities from the exercise event. 2) If the company’s stock price declines in value throughout the year, you have the ability to sell the shares as a “disqualifying disposition” before year-end. This would typically result in the paying income taxes on the difference between the Fair Market Value and the exercise price vs. AMT for the year.

Non-Qualified Stock Options (NSOs)

Non-Qualified Stock Options are less common than ISOs because they often do not provide the same tax advantages as ISOs, however, there are a handful of situations where NSOs are commonly issued. This includes when the company allows for “early-exercise” provisions, when the $100,000 annual ISO limit is exceeded, when issuing stock options to board members, advisors, or contract workers, or when employees are domiciled outside of the United States.

NSOs are subject to income taxes, as well as payroll taxes (Social Security & Medicare) if there is a spread between the FMV and the strike price at the time of exercise. That said, NSOs are most attractive to exercise & hold when there is very little / no spread between the current FMV and the strike price of the option grant. As the valuation for the company increases, the taxes can quickly become prohibitively expensive for most individuals, especially when the company is private and there is not a clear path to receiving liquidity for your shares.

If you are currently in a lower tax bracket than what you expect to be in the future (i.e. one spouse took time in between jobs or you’re launching a new business), then it could make sense to exercise NSOs even if your exercise price is discounted from the current FMV.

As the valuation for your company grows, “leverage” on the appreciation of your option becomes increasingly valuable. Leverage is most commonly thought of when you purchase a home. You get to acquire the full house by only paying a fraction of the total purchase price upfront. You take out a mortgage for the remaining balance and the difference between the home value and your mortgage balance becomes the amount of your home “equity”.

Home Value – Mortgage Balance = Home Equity

You can build more home equity in one of two ways:

  • Decrease the mortgage balance
  • Increase the home value

Equity value with stock options works in a similar way, except your exercise price is fixed. So for your equity value to increase, the stock price must increase. That being said, due to leverage, your equity appreciation is amplified relative to the stock price appreciation. I’ve included a side-by-side comparison to model the power of leverage in both your home & stock options.

Planning Corner with NSOs:

  • Maximize Target Tax Brackets – For individuals who expect to be in a higher tax bracket in the future or who have additional room to “fill up” their current tax bracket, then it can be valuable to model how many NSOs they could exercise and still stay within their target tax bracket.
  • Flexibility with Income Recognition – For an individual who anticipates being a lower tax bracket in the future, due to taking a gap in between jobs or maybe they won’t be vesting as many RSUs in the future, then deferring the exercise & sale of NSOs into a lower income year may be an attractive option to consider.
  • Pairing “Cashless Exercise” of NSOs with “Cash Exercise & Hold” with ISOs – This one is more advanced, but for someone who holds both ISOs & NSOs, you have the ability to use the high income tax (NSOs) to exercise & hold more ISOs within the same calendar year. This is because the highest AMT bracket is 28% vs. the highest income tax bracket is 37%. Since AMT is a parallel tax system, and you only pay AMT if your AMT exceeds your regular tax liability, you can pair a high income tax year with exercising ISOs to take advantage of an expanded “AMT Gap”.

Restricted Stock Units (RSUs)

Restricted Stock Units are most commonly issued at late, stage private and public companies. As the valuation climbs, the exercise costs for a new hire to purchase his / her stock options can become very high. Unlike stock options, you don’t need to purchase the underlying shares, so RSUs can still serve as a method to incentivize new employees who join a company at a later stage. Additionally, RSUs will retain value even if the company’s valuation declines in the future. While this isn’t an outcome anyone hopes for, RSUs do provide downside protection that stock options do not possess.

When RSUs vest, the number of shares * company stock price = compensation income. At a majority of private companies, RSUs are issued as “double trigger” RSUs, meaning that there are two requirements that must be satisfied before you officially “vest” the RSUs. The two “triggers” are: 1) Time-Based (i.e. 4-year vesting) and 2) Event-Based (i.e. IPO or acquisition). This is primarily to prevent employees from incurring a taxable event before they have the ability to receive cash from selling their shares.

While no one likes having a taxable event without receiving any liquidity, the drawback of double-trigger RSUs is that you lack control on the timing of when income is recognized. For example, let’s assume you were granted 10,000 RSUs on a 4-year vesting schedule when you joined the company three years ago. If your company goes public next year, you will recognize income for all 10,000 RSUs in one tax year. So while receiving more income is a nice “problem” to have, more of this income will likely be taxed at a higher rate than if the RSUs had vested across multiple years.

Planning Corner with RSUs:

  • Tax Withholding Adjustments – RSUs are considered “supplemental income” by the IRS and are subject to a default withholding rate of 22% if your income is below $1 million. In the year of an IPO, you may be vesting a significant number of RSUs that drive your personal income tax bracket above 22%. If you were to not make any adjustments, you would have a withholding deficit that needs to be covered. Even if the stock price declines in value from the IPO, you’re still on the hook for the taxes based on the stock price when the RSUs vested. Fortunately, many companies will allow you to update your withholding elections to be a higher rate than 22% (37% is the most conservative withholding rate as this is the top income tax bracket).
  • Pair High Income with ISO Exercise – Again, since RSUs are treated as compensation income just like NSOs upon exercise, this is the same concept as outlined above in the NSO planning corner.
  • Tax Flexibility with Generating Liquidity – Since RSUs typically “vest” at the IPO price (or stock price at subsequent vesting dates), the cost basis of these shares is likely going to be closer to the current stock price than the cost basis on the shares you purchased from exercising stock options. If the spread between the current stock price and your cost basis is small, this would have less tax consequences upon the sale than if you were to sell shares with a lower cost basis.

As you can see, there are a lot of factors to consider as you develop a plan for your equity. It’s important for your equity strategy to be dynamic and aligned with broader financial strategy. For how to incorporate your equity strategy into your financial plan, be sure to check out the final part of this series Part 4 – Financial Planning for an IPO.