Six Things to Know About Pre-IPO Incentive Stock Options

There are always a lot of financial and tax-planning implications to consider when deciding when to exercise incentive stock options (ISOs) you’ve been granted. One key question to ask yourself: Is your company public, or is it private, having not yet been through its initial public offering (IPO)?

Public vs. private does not impact the rules for exercising incentive stock options. These rules are the same either way. But when you exercise public company stock, you can often sell those shares at your convenience. When you exercise private company stock, you may never be able to sell at all.

So, what is the best answer: Are you better off exercising your ISOs pre-IPO, when the AMT impact may be at its lowest but you have a greater level of uncertainty? Or is it best to wait until your company goes public, knowing you can sell whatever shares of stock you exercise, and capture the profits accordingly?

While there is no perfect answer to this question, in this article, we will look at six things to consider if you have pre-IPO incentive stock options.

1 – How Do Pre-IPO Incentive Stock Options Work?

Pre-IPO ISOs follow the same principles and rules as public company ISOs. You are granted a set number of options. Your options vest over a stated vesting schedule, after which you can purchase company stock shares at the strike price of the option.

At exercise, Pre-IPO ISOs follow the same tax rules as public company ISOs. From a tax standpoint, there is no distinction between the two.

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This means, when you exercise pre-IPO stock options, the bargain element (the difference between the fair market value at exercise and the strike price of the option) is an adjustment for figuring the alternative minimum tax (more on this later). The fair market value for pre-IPO stock is often provided by your company and is known as a 409(a) valuation.

Generally speaking, pre-IPO ISOs can be exercised after your ISOs vest. Some companies, however, will also provide an early exercise provision, which allows you to exercise ISOs before they vest. Early exercise, coupled with an 83(b) election is a strategy that seeks to mitigate the tax impact, in part by helping you qualify for more favorable long-term capital gains rates when you sell your exercised shares.

Once you have exercised your options, you will own shares in your company. While pre-IPO shares have some similarities with publicly traded stock shares, there are also important differences, which we will discuss below.

2 – What if the IPO Is Late, or Never Comes at All?

It’s important to emphasize, even if an IPO seems imminent, if underwriting is already underway, or if your company is a “unicorn” (a company with a billion dollar valuation), there’s no guarantee the IPO will come soon, or indeed, ever.

• Early-stage companies often turn to private funding sources such as venture capitalists and bank syndicates to fuel their growth, making an IPO less urgent from management’s perspective.
• Alternatively, the company simply may not grow to the point that warrants an IPO.
• Even if your company has announced an IPO target date, it may delay the launch significantly if market conditions change.

Given the uncertainty, we recommend including a healthy dose of contingency planning in your financial plans. On the one hand, exercising pre-IPO ISOs can offer a handsome payout if fortune smiles on you. But what will you do if the IPO fails to launch, or it takes considerably longer than hoped for? How might this affect your financial well-being?

For example, let’s say you decide to exercise your ISOs pre-IPO, hoping to capitalize on the ground floor opportunity. You purchase the resulting stock with out-of-pocket cash, and may need to pay estimated taxes on the transaction. If an IPO takes forever, or never occurs, you might need to wait quite a while for your upfront purchase to pay off. Worst case, you could lose the money entirely.

It’s best to prepare for best- and worst-case scenarios when dealing with an uncertain future. In our illustration, this means not putting in more money than you could afford to lose when exercising a pre-IPO ISO.

3 –What Can You Do With Your Pre-IPO Stock Shares?

If you choose to exercise your ISOs pre-IPO, you will own shares of a non-public company. In some ways, this is similar to owning shares of a public company, but there are some important differences.

One of the most important advantages of an IPO is it gives you access to a public venue such as the NASDAQ or the New York Stock Exchange (NYSE). On a public exchange, you can trade stock shares among a global forum of buyers and sellers whenever these exchanges are open.

Pre-IPO, you may be able to sell your shares to another party, but it may not be easy to do so. Some plans may not allow for the sale of pre-IPO shares at all.

If you are allowed to sell to a third party, you will have to find a buyer among a much smaller pool of participants. And while there are exchanges for buying and selling private company shares, they can be opaque and illiquid compared to the public exchanges, with higher trading fees. It may be hard to tell whether you’re getting fair market value for your shares, or what that value even is.

Even if you can sell, there might be restrictions on the sale of pre-IPO stock, such as a right of first refusal. This means company board members or others may have the option to buy your shares from you before you can sell to just any third party. Your plan document should spell out what you can and cannot do.

4 – Are You Prepared for a Lockup Period, Blackout Periods, or Pre-Clearance?

Post-IPO, you’ll likely be able to sell your shares with greater ease and at a more transparent price. However, that’s usually AFTER a lockup period, during which you probably won’t be able to sell any of your shares. It depends on the agreement your company has with the investment bank helping your firm go public, but a typical lockup period includes the six months following the IPO.

After the lockup period expires, you may be further restricted by blackout periods. Blackout periods restrict certain employees from selling stock even after the company is public. For example, you might be subject to a blackout period for the 2 months preceding each quarterly earnings report. Then, you might have a 1 month “open window” when you can sell freely. Then another blackout period after the next earnings report. And so on.

Some select employees may be further restricted by needing to implement a 10b5-1 plan or needing to seek pre-clearance for any sale.

Of course, some restrictions may not influence your need to sell stock, such as hoping for stock appreciation or waiting to complete the long-term capital gain waiting period of longer than a year. (More on that below.) In any case, it’s important to account for these restrictions in your financial planning. Since you can’t tap into the value of your shares until you’re allowed to sell, you’ll want to avoid putting yourself in a financial bind by having a sudden need for liquidity during these periods.

5 – What are the Tax Implications of a Pre-IPO Exercise?

While taxes are an important consideration when exercising your ISOs, they’re especially crucial pre-IPO. Why? Because these shares can be more difficult to liquidate, meaning you may incur a tax liability upon exercise without being able to sell some of the shares you purchased to pay your tax bill.

ISO tax estimates are also relatively complicated, at least compared to non-qualified stock options. In particular, a pre-IPO ISO exercise may trigger a steep alternative minimum tax (AMT) liability, which you might need to pay for out of pocket.

The AMT is a dual tax system: the rate you’ll pay varies depending on the numbers involved. You calculate taxes owed using the rules for both ordinary income tax and AMT rates. You then pay whichever calculation is higher. Without diving too deep, you may be able to take an AMT credit later to recover some of the extra cost. But even so, you’ll need cash at exercise to cover the upfront AMT liability incurred.

In other words, taxes for a pre-IPO ISO exercise are a mixed bag.

If you incur AMT rates, you may increase your overall taxes owed. For AMT purposes, the aforementioned bargain element may add to your income in the year of exercise. The end result is that exercising and holding your shares can cause your upfront tax liability to increase. And you may be unable to sell some of your shares to cover those taxes.

However, if the share price continues to appreciate over time, you may also be exercising at a point when the AMT is the lowest it will ever be. We’ll take a closer look at that next.

6 – What Are the Tax Advantages of Exercising Your Incentive Stock Options Pre-IPO?

Despite the issues discussed above, there can also be tax advantages to exercising your ISOs pre-IPO, especially if your company stock appreciates substantially in the years following an IPO.

Most importantly, exercising ISOs early may help limit their total AMT effect. As touched on above, the exercise itself can trigger an AMT liability (depending on the assessed fair market value of the stock). But, waiting several years to exercise your options could generate an even higher AMT liability if the stock substantially appreciates.

To illustrate, we’ll compare two scenarios, pre- and post-IPO. In the post-IPO scenario, we’ll assume you exercise two years after the IPO at a nicely appreciated share price.

In our pre-IPO exercise, your bargain element is ($2 – $1) x 10,000 = $10,000. This means your total taxable income for AMT purposes will increase by $10,000. This relatively modest bump-up limits the possibility that you’ll be exposed to the AMT in the year of exercise. Even if we assume you are subject to AMT at a flat 28% tax rate, the total AMT bill would be $2,800.

If you instead wait to exercise your options until two years after the IPO, your bargain element equals ($35 – $1) x 10,000, or $340,000. This could mean a much larger AMT liability. In fact, at the same assumed 28% tax bracket, the total AMT bill is $95,200.

Of course, nobody can predict what the stock market or your company’s stock will do in the coming years. But as you decide when to exercise your options, it’s worth factoring in the potential for a post-IPO price appreciation.

Another potential tax advantage of a pre-IPO exercise is that the clock starts ticking at exercise for achieving a qualifying disposition, taxed at more favorable long-term capital gains rates. If you exercise pre-IPO, you have begun the holding period of your stock option on the date of exercise, which means you may have achieved the qualifying disposition holding requirement by the time the post-IPO lockup period expires. This gives you additional flexibility to sell your ISO shares sooner than had you waited to exercise post-IPO, and still obtain potentially preferential long-term capital gains treatment.

A Recap: Should You Exercise Your Incentive Stock Options Pre-IPO?

As you can see, there is no universally correct answer for whether to exercise your ISOs pre-IPO. There are potential advantages and disadvantages, depending on a future nobody can predict.

If you exercise pre-IPO and the stock appreciates, you could score a much lower upfront AMT bill, and start your qualifying disposition holding period sooner than later, giving you favorable tax rates when you sell the stock. On the flip side, you could instead be left holding unsellable stock of low or no value if the IPO never occurs, or the share price dramatically declines. Adding insult to injury, you could end up paying out-of-pocket taxes on the unfavorable exercise.

This conversation circles back to good financial planning, including how your options mesh with your personal financial goals. What do you hope to achieve? What risks you are willing to assume? What sort of cash flow do you have available at exercise? How much do you believe in the company? Where are you in your lifecycle?

Once you evaluate your choices in the scope of your greater plans, you can make a more informed decision about whether a pre-IPO ISO exercise makes sense for you. We can’t make the decision for you, but hopefully you now have the information you need to proceed. If you’d like to have a more personalized conversation with us about your particular circumstances, please be in touch.

This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.