As a tech professional, there are many ways for a liquidity event to happen to you. You can be a part of an IPO, a merger, a buy-out, a tender offer or even getting wrapped up in a SPAC. In any of those cases, your pre IPO stock options will all of the sudden become “real” money and you will need to make some tough decisions. You will be faced with tax ramifications that may range from thousands to millions of dollars. With so much money at stake, it is critical to understand how to navigate the decisions around your pre IPO stock.

The three most common forms of equity compensation will include incentive stock options (ISOs), non-qualified stock options (NQSOs), and restricted stock units (RSUs). Most early employees will receive pre IPO stock options: ISOs and NQSOs. RSUs will become more prevalent closer to an exit. You can get a sense of how close your company is to an exit based on what form of pre IPO equity they award you.

Each of these forms of equity compensation have different tax rules. You will also be faced with different decisions prior to and after the IPO. I will cover each in detail. Starting with the most complicated, ISOs, and ending with the most straightforward, RSUs. My goal is to help you understand what to expect and be prepared to make decisions with pre IPO stock.

ISOs

The most challenging pre IPO equity decision you will face is when to exercise stock options, especially your ISOs. Your decisions will start as early as the day you are granted your pre IPO stock options. ISOs are particularly complicated because they may trigger Alternative Minimum Tax (AMT). They also have holding periods that need to be understood.

I am going to assume this is not the first ISO blog you have read. I will link to a lot of awesome resources that you can get more detailed explanations from.

When it comes to ISOs it is all about answering the question of when. When to exercise your stock options? There is a chronological order of decisions. Starting with an early exercise, followed by exercising, followed by exercising after an IPO, and finally deciding to sell.

To better understand what you should do at each point you must first understand the role taxes play. With ISOs, it is a battle between turning ordinary income into long term capital gains vs. recognizing AMT (Alternative Minimum Tax).

When you exercise ISOs the difference between the strike price and the exercise price is not counted towards ordinary income or capital gains. You don’t recognize either until you sell them. This differs from NQSO, where even before you sell the shares, you are stuck with ordinary income tax.

If the difference between your strike price, exercise price, and ultimately the sales price is large then converting the difference to long-term capital gains can save you thousands if not millions.

However, the benefit of deferral until the sale comes with a catch in the form of AMT. The difference between the strike price and the exercise price is counted as an AMT preference item. The bottom line is if your income is high enough and the difference in this “phantom” income is large enough you may be stuck with a tax bill contrary to the benefits of ISOs.

Early Exercise

One way to avoid AMT is to minimize the difference between the strike price and the exercise price. ISOs must be awarded at the current pre IPO stock value. On the day you are granted your ISOs the difference between the strike price and exercise price will be zero. Hopefully, with time, it only goes up from there. Unfortunately, on the day you receive your grant it is unlikely that anything has vested.

This is where the early exercise comes in. An early exercise allows you to jump the gun, exercise your pre IPO stock options before you even own them, and shift the timing for AMT recognition. It also allows you to start the clock early on the qualified disposition. You do this by filling a form 83(b) and sending it to the IRS.

There are a few things you need to be aware of if you decide to early exercise options before acquisition or an IPO.

Things to consider before an early exercise

First, if you leave your company prior to those ISOs vesting you forfeit them back to the company at the price of the exercise. As an example let’s say you early exercised at a price of $5, you left when the company was worth $100, and before your shares were vested. You get back $5 per share, not the pre IPO stock value of $100.

Second, you need to commit dollars out of pocket to a non-productive and potentially dead asset. Unlike a publicly-traded company where you can do a cashless exercise, you will need to come up with your own funds to exercise shares of pre IPO stock. Your shares are also, technically, not worth anything until you have had a liquidity event or they are vested and you can sell them on a secondary market. You need to be able to financially commit money to an asset that may not return you anything for years or at all. When doing an early exercise consider yourself a venture capitalist.

Third, if you choose to do an early exercise later in your tenure, the exercise price and the strike price may have already spread. If you choose to accelerate the exercise of your pre IPO stock options that have not been vested, your income is sufficiently large, and the difference in strike and exercise price is large enough you may be faced with AMT. If the exit does not deliver, or come at all, you may be saddled with a tax bill and no way to pay it.

Finally, if you don’t hold until you meet the qualifying disposition then the early exercise price does not matter. Instead, your ordinary income is calculated as the difference between the strike price and (fair market value) FMV on the day those ISOs vested. Let’s say the strike price was $5, the early exercise price was $5, and the FMV on the day your ISOs vested was $10. If you sell early, your ordinary income will be the difference between the strike price of $5 and the vesting date price of $10.

With the meteoric rise of tech company valuations, those that early exercised looked brilliant. They saved an incredible amount of money in taxes and were able to get access to their assets faster.

If you are bullish on your employer and you have the funds to spare, then an early exercise may be one of the smartest decisions that you make.

Exercising Before an IPO or an exit

Much like an early exercise, exercising your ISOs before an IPO carries very similar risks. There are two big differences.

First, you are no longer at risk of forfeiture if you don’t stay long enough at the company. Regular exercising of your pre IPO stock options requires them to have vested. This means that once you exercise them, they are your shares for as long as the company is around.

The second, and the most important difference is the potential for AMT. Usually, vesting schedules follow a 1-year cliff with 3 years of a vesting schedule. Assuming you have been there for at least a year there is a good chance the company has increased in value. If your income is sufficiently large and the difference between the strike price and the exercise price is large there is a chance you can be required to pay AMT. This is particularly dangerous if the exit does not pan out. Think of WeWork employees who expected a large IPO, exercised their ISOs, paid AMT, and now are saddled with a bill. This happened to thousands of tech professionals in 2001.

Timing Qualified Disposition

If you are considering exercising before an exit you may decide to time it 6 months before. Usually, with a traditional IPO, there is a 6 month black-out period before employees can sell shares. By timing, the exercise 6 months before the IPO you can hit the qualified disposition rule of holding for 1 year after exercise.

Before deciding when to exercise stock options you should find out what kind of exit you are going through and what your options for selling will be. Your decision will change if it is a traditional IPO, direct listing, a tender offer, or a SPAC acquisition.

Exercising after an IPO or a public exit

There are two big changes when your company becomes publicly traded. First, your choice for exercising your options increases. Second, the amount of risk you take significantly decreases.

Sell to Cover

During the private years of your employer, you had to put up your existing capital to exercise the pre IPO stock options. Once your company becomes public you have a choice to sell to cover. This choice sells the exact amount of shares at the current market price needed to pay for all the shares at the original strike price. The downside is that you will recognize ordinary income on all the shares sold to cover.

Derisking AMT

With the company publicly traded the chance that you will recognize some value from exercising your shares increases. To meet the qualifying disposition you will still need to hold the shares. However, there are few additional benefits to doing this during the company’s public years.

First, if you recognize AMT there is a better chance you can reduce the taxes from future capital gains via AMT credits. While the IRS is desperate to tax you, they will tax you only once on each transaction. If you have been taxed once when exercising your ISOs you can offset future capital gains tax from the sale of these shares via AMT credits. Unfortunately, some highly compensated employees, who frequently fall under AMT rules, may have a hard time recovering these credits in full.

Second, most financial advisors will encourage you to exercise your ISOs at the beginning of the year. This gives you the entire year to evaluate the direction in which the shares move. If the shares drop significantly in value by the end of the year, around 30% of the spread at exercise, you may be better off triggering the disqualifying disposition. At this point in time, the regular tax will probably be less than the AMT. Once the year is over your AMT will be locked in. It is important to evaluate tax ramifications before December 31st.

When to exercise your pre IPO stock options or options in now a publicly-traded company will depend largely on how much AMT you will recognize. If possible, it would be wise to exercise over multiple years. Each year you should evaluate how much can you exercise before triggering AMT.

This process is far from easy and requires a strong understanding of ISOs, AMT, and your own financial situation. I highly recommend you find a good tax advisor, CPA, tax attorney, or financial advisor. You can start by clicking HERE.

Deciding to sell shares from ISOs

There are several scenarios where you may sell before you meet the qualifying disposition.

The first case is if you sell to cover. This will be available to you as a way to exercise your shares once the company is publicly traded.

Beyond selling to cover you may also decide to sell additional shares to cover AMT. If you decide to exercise at the beginning of the year you can evaluate your potential tax impact at the end of the year. At that point in time, you can consider selling additional shares to cover AMT or any ordinary income you may have recognized.

Finally, you will need to decide if you want to sell at the time you meet the qualifying disposition. A year after the exercise the share value may be significantly higher than it was when you originally exercised. This will be especially true if you exercised before a successful IPO. While your tax impact will have been reduced you may still feel hesitation to sell and recognize capital gains.

Remember, if you recognized AMT when exercising you may be able to offset some of those capital gains with AMT tax credits.

Beyond that, as with any highly appreciated and very concentrated investment, you need to evaluate the risk vs reward vs tax trade-off.

How bullish are you on your employer? How would your life change if the value doubled and how would it change if it dropped in half? Are you happy with your profits? Can you take some off the table? Are there other goals you want to make sure are locked in?

You may feel that you have already succeeded by avoiding crazy taxes and getting amazing appreciation on your employer stock. But to have a good trade you need to be right twice. When you buy (exercise) and when you sell.

NQSO

When it comes to pre IPO stock options, decisions, and taxes NQSOs are much more simple than ISOs. When you exercise your NQSOs the difference between the strike price and exercise price always gets counted as ordinary income. If you decide to hold your shares, any appreciation between the exercise price and the sale price will be counted as capital gains. Either long or short, depending on when you decide to sell.

Unlike ISOs, there is no additional tax benefit for holding your NQSOs once you exercise. For this reason, most financial and tax advisors strongly recommend that you sell your shares once you have exercised them.

However, if your employer is pre IPO that decision is not so simple.

Capturing Long Term Capital Gains

The lack of a liquid market may prevent you from selling any shares. You may be able to sell them on a secondary market, but it is not always a guarantee, and it may come at a lower price. In addition, you may be aware of an upcoming exit at a higher price point.

This means you have a decision. Do you exercise now and sell after the IPO or do you exercise after the IPO and then sell the shares?

If you exercise now you can start the timer on long-term capital gains between the exercise price and the sales price. If you are confident that the IPO will happen and at a higher valuation this may seem to be a tempting proposition. It may be tempting enough to risk that you pay ordinary tax on gains you never recognize. Once again, let’s reflect on employees of WeWork who had NQSOs.

However, if you have enough in cash to pay for the tax bill and you are comfortable taking the risk this may be a worthwhile strategy.

Balancing AMT from ISOs

Frequently an equity grant will come with both pre IPO stock options: ISOs and NQSOs. While NQSOs don’t have an added tax benefit like ISOs they are not completely useless when it comes to tax strategies.

If you have exercised enough ISOs to trigger AMT you may have a budget to exercise some NQSOs at the same time with minimal additional tax impact.

AMT is a parallel tax system to ordinary income. It strips away certain deductions and factors in certain tax benefits such as the ones ISOs have. AMT is compared directly to ordinary income tax and you receive the larger of the two tax bills.

If your AMT far outstrips your ordinary income you may have some bandwidth to exercise NQSOs until the two tax bills are roughly the same. However, AMT is impacted by ordinary income. There is a higher chance you go beyond the phase-out. Therefore, if you do decide to execute this strategy it is really important you model it out with the help of a professional.

Don’t Destroy Time Value

One critically misunderstood aspect of pre IPO stock options is time value. All stock options consist of two sources of value. Intrinsic value and time value. Intrinsic value is simply the difference between the strike price and exercise price. The higher the exercise price is above the strike price the more intrinsic value that you have. The second type of value that is less understood is called time value.

Time value is the benefit of being able to see where things go. It is leverage. As an owner of a stock option you get the benefit of appreciation and avoid all risks of depreciation or loss. You have the ability to trigger the purchase at any time over a period of 10 years with employer stock options. The more time you have until the options expire the more time value you have in comparison to intrinsic value. The ratio of intrinsic value and time value is usually used by financial advisors to evaluate if you should actually exercise your stock options. The more time you have and less intrinsic value the more advantageous it is to hold your stock options.

RSU

Of the three forms of equity compensation, RSUs may be the simplest and yet the most frustrating form of equity compensation at an IPO or exit.

Unlike pre IPO stock options, for most RSUs awarded prior to a public exit, there is a double trigger requirement for them to actually vest. The first trigger is the time you are at the company. This will follow the typical one-year cliff with three years of a vesting schedule. The second trigger is a liquidity event.

RSUs are really simple in the way they get taxed. When they vest the number of shares that are vesting are multiplied by the current stock price. That amount is considered ordinary income. It is taxed exactly the same way as your W-2. FICA taxes and all.

With RSUs there are no decisions to be made except for when you sell them. Once they vest, they get taxed and they are in your possession.

RSUs can be frustrating for a couple of reasons.

Tax Shrink

The first is the tax shrink that you will experience from the number of shares you are promised to the number of shares that you get. When your shares vest some will automatically be sold by your employer to cover some taxes. Unfortunately, it is very unlikely it will be enough to cover all the taxes. That means that come April 15th there is a good chance you will owe additional taxes. The only way to get around this awful experience is to have the right expectations of how much taxes you owe, how much taxes have been deducted, and how much taxes you still need to pay. When your RSUs have vested it is usually a good idea to go through these three numbers to set your expectations right.

RSUs and Traditional IPOs Don’t Mix

The second reason is much worse. If you received an RSU grant far in advance of an IPO or a public exit many of those if not all will have met their time vesting criteria. If you have an IPO on the horizon you are going to experience potentially the largest tax event of your life.

All of your RSUs will vest once the liquidity trigger is pulled. All of them will be calculated for purpose of taxes. This could potentially push you all the way to the top tax bracket.

Alternatively, if your company was public during the years your time criteria was met, you would have received RSUs and paid ordinary income taxes on them. Your ordinary income would have been spread over a period of multiple years. Enough so that you potentially wouldn’t be pushed up into higher tax brackets.

Despite how unfortunate this reality is you are significantly more in danger during and after a traditional IPO. If you have a traditional lock-up period your employer will usually withhold some taxes on the IPO by selling some of your shares. Even if you don’t get the proceeds, the withholding will cover some of the tax bill. However, as mentioned before, this usually will not be enough.

In the following 6 months, if your share price drops you will be faced with a tough but necessary decision to sell the additional shares at a lower stock price. But while you are selling at a lower stock price the additional tax bill has been calculated on the higher share price on the day of the IPO. This effectively increases your tax rate. It is a tough pill to swallow and why I am completely against offering traditional IPOs and lock-up periods for employees with RSUs.

Avoiding ISO AMT with RSUs

Finally, while RSUs will saddle you with higher ordinary income taxes you can always use this to your advantage. If you have ISOs, consider exercising them in the year of the IPO. Your ordinary income may be high enough where the AMT will not be triggered.

Summary

No matter what the dollar amount is the decisions on your pre IPO stock options and RSUs are the same. Whether you are a director level or a senior engineer you will be faced with similar choices. For most individuals, an IPO or a big exit will happen once in their life. It will be their first time and it will be their last time. That is why it is so critical to make sure you understand what decisions you need to make.

Because these decisions are so important, so time-sensitive, and can be so complex I highly recommend you work with a qualified tax professional. Find someone that has experience with tech employees.

If you need help figuring out your pre IPO stock options or RSUs or getting introductions to qualified CPAs, tax advisors, and tax attorneys don’t hesitate to reach out to us. You can schedule a quick 15-minute call by clicking HERE.