Getting professional advice from lawyers, tax professionals and financial advisors is often your best course of action, but it’s helpful to understand some of the key questions you’ll need answers to before and after your company has an IPO so that you can plan ahead.
Consider when and how to exercise stock options, when to sell company stock, what tax issues you could be facing, and how to leverage your newfound assets to provide financial security not just for yourself and your household but also for future generations.
When and how to exercise stock options
Your stock options may be vested or unvested.
- If you have unvested shares, the IPO usually won’t change the vesting schedule – although sometimes the IPO deal involves immediate vesting of options as part of the transaction.
- If you have vested options, you’ll need to determine when to exercise them.
The first important consideration is the strike price vs. the internal company valuation of your options. If the exercise price exceeds the fair market value of the shares, exercising your options isn’t a smart financial move.
Timing also matters. Exercising options early and meeting long-term holding requirements before your company exits could provide significant tax savings. Exercising options months prior to your company’s IPO filing could allow you to benefit from long-term capital gains rates as soon as you become able to sell company stock after the IPO.
However, exercising options could also result in incurring significant tax liability with no immediate cash proceeds to pay the IRS. There’s also no guarantee the IPO will actually happen, and there’s non-zero risk that your options could go underwater and you could experience a loss.
Additional reading: SPAC vs. Traditional IPO: Valuation, Lockup Period, and Employee Equity
When to sell company stock
After an IPO, there’s typically a 180-day lockup period during which you can’t sell your company stock. Once the 180 days have passed, you’ll need to decide whether to sell some or all of the company stock you own. Several important factors need to be evaluated in determining when to sell and how many shares to offload including:
- Diversification: It’s not a good idea to be too heavily invested in any one company, especially not one that also provides your paycheck. If the company faces financial trouble, you could end up both out of work and with an investment that plummets in value. More on this topic here: Diversify Your Portfolio: How Startup Employees Over-invest in Tech
- Tax implications: The sale of company stock could push you into a higher tax bracket, resulting in a substantial tax bill. The length of time you’ve held the stock will also affect whether you’re taxed at the long-term or short-term capital gains rate.
- Timing: Stock prices are often volatile after an IPO. It’s best to develop a long-term strategy to harvest the maximum gains and minimize the risk of price drops.
Timeline of events: When to start preparing
In an ideal scenario, you would start working with financial and tax advisors (and for some cases, a trust & estate lawyer) more than one full year before an IPO or liquidity event.
However, we know that one year isn’t always possible, and the timing of an IPO can often fluctuate. If you have some degree of certainty of the event, it’s highly advantageous to take the steps we describe below as soon as possible — even if not one full year before, even a few months will net you several of these benefits.
Once the IPO does happen, you can play a bit of catch-up, but you’ll already have missed out on a key window of opportunity. The tax system and wealth management as an industry highly favor early birds.
Why one year? At that time, there is typically still a discount between the 409a common valuation and the price at moment of sale. That creates the following temporary opportunities:
- Evaluate the timing of more favorable stock exercises from a tax bill perspective.
- Defer current year tax deductions to the following year when the liquidity event will take place and will be of greater value to you.
- Pay less in advisory fees. You can build a strategy around when to sell shares, which securities to sell, and where to reinvest proceeds, all at a lower cost now compared to what you will pay after a liquidity event. Firms charge an AUM (Assets Under Management) percentage fee for advisory services, which does not take into account illiquid assets (such as stock options) as part of your total.
- Create a trust to hold a significant amount of assets. If you are going to create a trust, you want to move assets into it at the lowest possible value. The value of assets at the time of transfer eats into your maximum lifetime estate tax exemption.
Potential tax issues: AMT and gifting/donation considerations
Several tax issues have already been raised, but there are other issues to consider as well.
Exercising vested options or selling stock shares could trigger the Alternative Minimum Tax (AMT) which makes tax filing more complex and potentially more costly.
Tax savings could also be achieved by gifting stock to family members or donating options to charity prior to the IPO. And long-term tax savings could be achieved through the creation of a tax-advantaged trust, by transferring company stock to a trust before the market value increases, or creating a donor-advised fund to make tax-advantaged transfers to charities over multiple years.
Tax advisors and estate planning attorneys can provide advice on both planning for the immediate tax implications of the IPO and developing a long-term plan to effectively reduce the amount owed to the IRS.
Additional reading: Graduating from TurboTax: Do You Need a Tax Advisor (CPA)?
After the IPO: Investing your windfall
The sale of stock options after an IPO could leave you with substantial assets to manage and a new set of tax considerations in a year of atypically high income.
Choosing the right investment products is vital to protecting and growing wealth, but building a diversified portfolio that exposes you to the right level of risk is only the beginning. Other important considerations include:
- Protecting assets from potential loss due to lawsuits and costs-of-aging such as nursing home bills or substantial healthcare expenditures as you age.
- Choosing appropriate tax-advantaged investment accounts and minimizing the tax implications of investment gains.
- Developing a medium-term plan for the management of wealth in case of incapacity.
- Developing a longer-term plan to effectively transfer assets to the next generation while minimizing estate taxes, reducing the chances of a contested will, and protecting assets in cases of spendthrift heirs.
Financial advisors can provide assistance in determining the appropriate mix of assets to invest in, while tax and legal advisors can help you develop a smart tax strategy and make plans for the future.
Additional reading: Investment Strategies for a Large Windfall or Inheritance
Make sure you’re prepared for your company’s IPO
Harness Wealth can pair you with the advisory firms you need to provide advice across your financial, tax, and legal concerns throughout the IPO process. To identify the right advisory firms for you, get started here.