My Company Is Going Public, Now What: What To Do With your ISOs

Readers welcome back to our pre-IPO crash course for tech professionals. An Initial Public Offering comes with many changes, challenges, and opportunities for your financial plan, all of which we’ll continue to explore together.  Last time, we kept things high...

Readers welcome back to our pre-IPO crash course for tech professionals. An Initial Public Offering comes with many changes, challenges, and opportunities for your financial plan, all of which we’ll continue to explore together. 

Last time, we kept things high level with info-driven prep for your employer’s IPO. Today, we’re going to dive deeper into incentive stock options (ISOs), as well as the opportunities and potential complications you might face when exercising them prior to the IPO.

Are you surprised? Yes, under certain circumstances, you may be able to buy and sell shares of the company you work for even before they are publicly traded. 

But the transactions can be complex and prompt an entirely different set of circumstances you need to understand. Ready to take a look at your pre-IPO ISOs (embrace the acronyms!)?

Glossary of Terms

Sometimes it feels like the world of stock options has its own language. We don’t want to throw you into the deep end without a reliable floatation device, so we’ll quickly define some key terms to help you more strongly connect with this piece.

  • Exercise/Strike Price
    • The price that a security can be purchased when exercising an option. This is a predetermined amount that the company issues when granting your options.  
  • Bargain Element
    • The difference between the stock’s fair market value and the purchase price upon exercising. Let’s look at an example. Say you can purchase a share (also known as the exercise price) for $20 and the fair market value of the share is $100. The bargain element, or the difference between the market price and the exercise price, is $80.
  • Lock-up Period
    • A window of time where investors are unable to sell shares of a certain investment. Most companies issue a lock-up period right after an initial public offering to avoid the shares flooding the market and ultimately depreciating the share’s value.
  • Alternative Minimum Tax
    • A separate tax filing system for high-income earners. It uses a different set of rules to ensure that high-earners pay enough taxes in a given year by placing a limit on deductions and credits. There are two AMT rates, 26%, and 28%. Income from exercising some stock options can count toward AMT income. 

Now that you’re familiar with some basic stock-speak, we’ll jump further into the specific options and consequences of your pre-IPO ISOs.  

How Do Pre-ISOs work?

Exercising your ISOs post-IPO is fairly straightforward. Let’s do a quick recap. If you’ve been granted ISOs, you may buy them at a fixed price regardless of the current (or future) market price before a certain expiration date. Both the exercise price and the current trading price are easily identifiable. Tax liabilities are delayed until the sale of the shares.

In contrast, assessing the value of your pre-IPO shares is much more opaque because it’s not yet traded on the open market. To estimate the value of your shares, check out your company’s most recent fair value assessment. Keep in mind this number is just an educated guess. 

This means that if you choose to exercise your company’s ISOs before its IPO, you’re not really sure whether you got a good deal or not. Also, buying your company’s shares before it goes public might trigger an Alternative Minimum Tax (AMT) for high-income earners. More about that later.

There are some other risks as well:

  • You’ll likely need a significant amount of cash on hand to exercise your options. Even if you have the money, consider investment alternatives. What could you spend the money on other than these ISOs? Decide whether other investment options might be a better choice and more aligned with your goals.
  • Should you want or need to sell your shares before the IPO, you may not easily find a buyer. Or the buyer is offering a price you consider below fair market value. Or you may be restricted in your selling options based on the company’s board of directors’ right of first refusal. So check your plan document.
  • The IPO could be delayed or never happen at all. This could put you in a tight cash spot upfront. 

Some Airbnb Inc. employees faced this dilemma. A key group of early team members were granted stock options in 2010, but the IPO was almost 10 years coming. Finally, the company went public literally weeks before the stock options were set to expire. 

Luckily for them, early stock exercising made sense in this case as the stock price soared from $68 on the day before the IPO to $146 within 24 hours. It has continued to climb since.

Doordash Inc. is another example, with its stock soaring 80 percent during its IPO in December 2020.

Are there any benefits to exercising ISOs prior to the IPO?

Yes! Exercising ISOs before the company goes public remains an attractive investment opportunity for several reasons. 

First, you won’t have to worry as much about the lock-up period after the company goes public. A lock-up period prevents employee stockholders from flooding the market and depressing the stock’s price. It usually lasts for about 6 months. 

Next, selling your ISOs early starts the clock on the holding period, paving the way for long-term capital gains tax treatment. Equities sold after holding them one year or longer are privy to this preferential tax treatment. 

Lastly, even though the sale could trigger an AMT liability, that liability could be lower than what you would have to pay if you exercised your options later. Again, more about AMT in a little bit.

With those conditions in mind, timing is key. If the timeline of the planned IPO is known, consider this general strategy:

  1. Exercise your ISOs six months before the date of the IPO. Your holding period starts at this moment.
  2. If all advances as planned, the company goes public six months later and the lockup period commences—another six months.
  3. The lockup period expires around the same time you will have held your shares for at least one year, allowing you to then sell your shares and benefit from the more favorable long-term capital gains tax. 

Of course, you may wish to hold on to the shares.

That’s a lot of if’s and you can see why the privilege of exercising ISOs before the company goes public comes with important risks. It’s critical to understand these risks before deciding on a path that’s best for you. 

When should you NOT exercise your ISOs?

Avoid exercising your ISOs if any of these three conditions apply:

  1. No IPO is in sight. Venture capitalists and bank syndicates are more and more frequently stepping in to provide the necessary financing for a company to grow and expand, making an IPO less desirable or critical from the managers’ perspective.
  2. You don’t have the cash on hand to purchase the options or you don’t have the cash to pay the AMT (see below) if it comes to that!  
  3. You can’t afford to do without the cash for an unspecified amount of time or you can’t afford to lose it short-term in case the stock underperforms.

How does the AMT fit in?

Finally, the section you’ve all been waiting for! What does alternative minimum tax have to do with exercising your ISOs in the pre-IPO stage?

The Alternative Minimum Tax (AMT) is a separate tax-filing process. It affects some high-income earners who pay taxes via the AMT rules, rather than ordinary income tax rules. By limiting the tax deductions and credits once certain income thresholds are reached, the AMT is designed to ensure that high earners pay their fair share of taxes.

If you are among those high-income earners, exercising your ISOs before the company is public could count toward your AMT yearly total, which would cause a hike in your tax liability. Why?

For AMT purposes, the difference between the fair market value and the purchase price of the option—known as a bargain element—could be added to your income in the year of the exercise.

Putting all the pieces together:

What does this scenario look like in real life? Let’s say your purchase 200 shares pre-IPO at the discounted price of $20, while the fair market price is $80. Your bargain element is $60, and your taxable income would increase by $12,000 (60 x 200).

If this scenario applies to you, consider whether or not you would have the liquidity to pay taxes on the $12,000.

At the same time, exercising early could mean a lower AMT than if you waited until the stock increases in value after an IPO. When it comes to equity compensation, tax planning is the name of the game. Understanding your tax liability can help you make well-informed and intentional decisions to make the most out of your shares. 

Plan Ahead and Work with a Professional

Are you a DIYer when it comes to home repairs? It’s great if you can replace your garbage disposal, but you may have also discovered that your efforts ended up costing you considerable money, time, and stress. 

Investing can be similar, especially in the technology industry full of equity compensation. It’s often best to work with someone with deep experience with these intricate investment and tax situations. 

It’s important to have the right people in your corner as you transition your securities from private to public. As always, we are here for you and looking out not only for your best interests but also your goals and values.

Our expertise in evaluating your investment options, including ISOs, balancing your portfolio, and reviewing your goals will bring you the confidence and peace of mind that you are making the right decisions.

Please contact us anytime. We’ll be glad to start a conversation.

Stay tuned for the next piece of the series where we’ll explore the vast world of restricted stock units (RSUs).