The choice of when to exercise your incentive stock options can be a difficult one, with serious implications for financial planning and taxes. When your company is still pre-IPO, that opens up an entirely separate set of concerns that you may need to be aware of.
The issues associated with pre-IPO incentive stock options (ISOs) are particularly relevant now, as early-stage companies increasingly find private funding sources and delay the date of their IPO. As the length of time between startup and IPO increases, more and more employees are facing the question of the costs and benefits of pre-IPO ISO exercise.
In this article, we will look at six important things to consider if you have pre-IPO incentive stock options.
1 – How Do Pre-IPO Incentive Stock Options Work?
Most of the stock option explanations you’ll find online and in textbooks assume that the company’s stock is publicly traded. With a public market, you can easily compare the exercise price of your incentive stock options to the current trading price of your company’s stock to get a good estimate of what your options are worth. Even if you don’t plan to exercise or sell right away, you have a good baseline value to use in decision making.
In contrast, pre-IPO shares don’t trade on the open market and therefore may not have a readily defined price. If you choose to exercise pre-IPO, the estimated value of the stock you purchase is likely based on the most recent assessment of your company’s fair value, which is calculated periodically.
You’ll likely need to wait until the next valuation to know whether or not the stock price is up or down, and whether your exercise was a good decision.
Once you have exercised your options, you will own shares in your company. While these shares have some similarities with shares of publicly-traded companies, there are also important differences, which are discussed below.
2 – Is There an IPO Date in the Near Future?
What does it really mean to be pre-IPO? Simply that your company is not publicly traded, but may do an offering in the future. However, that is not necessarily a guarantee that the IPO will come soon, or indeed, ever.
When doing your financial planning, you should take into account the possibility that an IPO may come later than expected, if at all. More and more frequently companies may be able to secure necessary financing from venture capital and bank syndicates, which makes an IPO less urgent from management’s perspective. Or alternatively, the company simply does not grow to the point that warrants an IPO.
Has an IPO date been announced? Or at least a target year or quarter? Even in the case of companies that have already begun the underwriting process, IPO dates can be delayed significantly if market conditions change.
As a result, you should take contingency planning into account when thinking about your pre-IPO exercise plans. What happens if the IPO takes place later than expected? How would this affect your cash flow and tax situation? For example, what if you exercise your pre-IPO incentive stock options, pay for them in cash, pay the tax, and the IPO never occurs. You may find yourself paying cash for something that you may never get back in return. It’s best to be prepared for good and bad outcomes when dealing with uncertain future events.
3 – What If the IPO is Late (Or Never Comes At All)
If you choose to exercise 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.
For example, while you may be able to sell your shares to another party, in some instances 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 someone else to buy the shares. While exchanges for buying and selling shares of private companies exist, they can be opaque and illiquid compared to public stock exchanges. You may find that you are only able to sell your shares at a price below what you consider to be fair market value.
After all, one of the most important advantages of an IPO is to provide you with an easy venue for buying and selling shares. Prior to listing, you may find this lack of venue to be an obstacle in realizing the full value of your options.
Even if you can sell, there may be restrictions on the sale of your stock pre-IPO, such as the right of first refusal. This means that the board or another party has the option to buy your shares from you before you can sell to a third party. Again, you should check with your plan document to see what you can and cannot do.
4 – Are You Prepared for a Lockup Period?
Once an IPO takes place, the sale of your shares will likely become much easier, and pricing more transparent. However, you should be prepared for a lockup period that may restrict the sale of stock. During this period, often 6 months post IPO, you may not be able to sell your shares of stock per the agreement your company has with an investment bank (the company helping your firm go public).
Of course, you may wish to hold on to your shares during this period for other reasons, hoping for stock appreciation or waiting for the long-term capital gains period to complete. Since long-term capital gains are taxed at a lower level, it may be advantageous to exercise your incentive stock options early so that you can begin the holding period requirements, meaning a post-IPO sale will be considered a long-term gain sooner rather than later.
In any case, it’s important to take the lockup period into account for your financial planning, since you won’t be able to tap into the value of those shares until after the lockup period has expired should you have a sudden need for liquidity.
5 – What are the Tax Implications of a Pre-IPO Exercise?
While taxes are always important to take into account when considering the timing of exercising your incentive stock options, it’s an especially crucial consideration for pre-IPO companies. 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.
The tax effect of your exercise will depend on whether you hold incentive stock options or non-qualified options (NSOs). The pre-IPO sale of ISOs in particular can create tax issues, because the exercise of ISOs may trigger an alternative minimum tax (AMT) liability.
The AMT is a dual tax system, where taxes owed are calculated using both the rules for ordinary income and an AMT calculation. You then pay the higher of the two numbers, AMT or ordinary income. So, by exercising your pre-IPO ISOs, you can potentially increase the overall amount of taxes you owe. However, you may also be exercising at a point when the AMT is the lowest it will be if the price continues to appreciate.
For AMT purposes, the bargain element (the difference between the exercise price and fair market value at the exercise of your ISOs) may add to your income in the year of exercise.
Any pre-IPO ISOs you exercise may increase your taxes for AMT purposes, but won’t increase your regular tax liability (assuming you don’t sell your ISO shares during the year.) If your AMT taxes exceeds your regular taxes, you’ll have to pay more than you otherwise would.
The end result is that simply exercising and holding your shares can cause your tax liability to increase. If you need to sell some of your shares to cover those taxes, you may not be able to.
The tax effect is somewhat different for NSOs. Exercise of your NSOs won’t trigger an increase in your AMT liability, but the bargain element is still taxable as ordinary income. Therefore, exercise will increase your income in the year of the exercise, which can increase the taxes you will need to pay.
6 – Advantages of a Pre-IPO Exercise of Incentive Stock Options
Despite the tax issues discussed above, there can be considerable advantages to the pre-IPO option exercise. Many employees of pre-IPO firms are hopeful that there could be substantial stock appreciation in the years following an IPO. If this turns out to be the case, then exercising in the pre-IPO period can have tax advantages in the long run.
For ISOs, exercising early can help to limit the total AMT effect. While the exercise itself can trigger an AMT liability (depending on the assessed fair market value of the stock), waiting several years to exercise your options could increase the AMT effect substantially if there is significant stock appreciation.
Imagine two alternative scenarios, one in which you exercise your ISOs pre-IPO, and another where you exercise two years later after the IPO has gone to market, the lockup period has expired, and the price of the stock has appreciated.
If you exercise pre-IPO in this example, your bargain element is ($2 – $1) x 10,000, or $10,000. So your taxable income for AMT purposes will increase by $10,000, limiting the possibility that you’ll be exposed to the AMT in the year of exercise. If we assume you are subject to AMT and assume at a flat 28% tax rate, the total AMT bill will be $2,800.
Waiting until the post IPO period to exercise your incentive stock options, however, means that 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 will do in the coming years. But given the potential for price appreciation between IPO and following the IPO, you should take this possibility into account when doing your planning.
The other tax advantage of pre-IPO exercise to consider is that the clock for a qualifying disposition begins at exercise. If you exercise pre-IPO, you have begun the holding period of your stock option on the date of exercise. This means that you may achieve the qualifying disposition holding requirement when the post IPO lockup period expires. This, in turn, may give 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.
What Now with Your Pre-IPO Incentive Stock Options
Any incentive stock option exercise decision should also be considered alongside your other financial planning needs. But as you can see, the unique issues associated with pre-IPO option exercises make careful planning especially urgent.
While there may be several advantages to a pre-IPO exercise such as a lower AMT bill or the start of your qualifying disposition holding period, the potential benefits should be weighed against the risk of buying a stock that you may never be able to sell.
This conversation often circles back to good financial planning. Discuss what you are looking to achieve, what risk you are willing to assume, how much you believe in the company, and where you are in your lifecycle.
Once you evaluate the option in the scope of a larger plan, you can be informed to make a good decision about whether or not a pre-IPO exercise is a good idea for you.
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.