Need advice: early exercising pre-IPO ISOs

[LoneAspen]

Looking for some info/advice here...

I'm two years into a four-year vesting period at a pre-IPO company, and have ISOs (Incentive Stock Options). The company is doing extremely well and my gut tells me they'll file for an IPO in the next 6 to 12 months (that is ONLY a gut feeling, nothing more).

We have the ability to early exercise our options, but to date I have not bought any of my options (vested or not), because I wanted to be a little more sure things were going well, and the company would file for an IPO. However, now the difference between my strike price, and the common share price, is high enough that there will be significant AMT tax that I would owe on the spread - enough that it's going to wipe out my savings, if not cost me even more than that.

Because of that, the way I'd like to time it is...when the company actually announces they're filing for an IPO, I'd like to early exercise everything the next day. I would owe a lot of AMT the next year, but I'd be okay with that knowing the company was proceeding to an IPO, and I could sell just enough stock after the blackout period to help pay the AMT taxes. My goal is to hold on to all my shares (minus what I need to sell to pay AMT) for at least one year for capital gains treatment, probably longer, because I'd want to hold off and see if the company gets acquired after going public, which would push up its valuation even more.

My concern is that when the company announces an IPO, some kind of window shuts on us being able to early exercise. I'm waiting to get an "official" answer from the company on this, but thought I'd reach out to folks who might have been in this situation before to get their experiences.

When a company files for an IPO, I'm aware of quiet periods and things like that surrounding public statements, but are there rules in place that would prevent employees from early exercising their options right after the announcement?

Thanks!

[jimnjana]

Some of your questions don't have an answer until company publishes IPO docs. It might make sense to exercise some options now so that you have shares prior to IPO that may or may not be able to be sold into any IPO share price gains.

[wanaberetiree]

Quote:

Originally Posted by LoneAspen Looking for some info/advice here... I'm two years into a four-year vesting period at a pre-IPO company, and have ISOs (Incentive Stock Options). The company is doing extremely well and my gut tells me they'll file for an IPO in the next 6 to 12 months (that is ONLY a gut feeling, nothing more). We have the ability to early exercise our options, but to date I have not bought any of my options (vested or not), because I wanted to be a little more sure things were going well, and the company would file for an IPO. However, now the difference between my strike price, and the common share price, is high enough that there will be significant AMT tax that I would owe on the spread - enough that it's going to wipe out my savings, if not cost me even more than that. Because of that, the way I'd like to time it is...when the company actually announces they're filing for an IPO, I'd like to early exercise everything the next day. I would owe a lot of AMT the next year, but I'd be okay with that knowing the company was proceeding to an IPO, and I could sell just enough stock after the blackout period to help pay the AMT taxes. My goal is to hold on to all my shares (minus what I need to sell to pay AMT) for at least one year for capital gains treatment, probably longer, because I'd want to hold off and see if the company gets acquired after going public, which would push up its valuation even more. My concern is that when the company announces an IPO, some kind of window shuts on us being able to early exercise. I'm waiting to get an "official" answer from the company on this, but thought I'd reach out to folks who might have been in this situation before to get their experiences. When a company files for an IPO, I'm aware of quiet periods and things like that surrounding public statements, but are there rules in place that would prevent employees from early exercising their options right after the announcement? Thanks!

I am not sure where to start, there are so many issues involved into such decision.

I am for one, always liked the idea to exercise as soon as possible. But it all based on whether you believe in the company and price. If a strike price is low (I was buying at $0.06-0.18 with value at the time ~$1.00) then it's one story.

I also witnessed a situation just before the doc.com crash when people were given a choice to do "early exercise" and paid $4-6 per share with valuation at ~$100 and then saw the price collapsed to almost $2 per share!!! And guess about those people tax liability.

Not sure if I gave any advise, just grounds for thoughts...

[Animorph]

Kind of tough that you don't have enough to just buy now. I think I'd exercise what you feel comfortable with now. Then you'll have some shares to sell in a year that could cover further expenses, depending on IPO timing. I bought my ISO's early at a total cost of $3k and still below the AMT. Guys that bought later and had AMT problems were jealous. That problem is only going to get worse unless things crash, which wouldn't be good either. Hence, some now, some later.

[clifp]

With the caveat that you almost certainly want to talk to CPA to fully understand the complicated tax ramification before doing anything assuming this a significant sum of money say >$25,000 a few thoughts.

The benefits for exercising now is that you will only owe AMT taxes on the difference between the exercise price and today fair market value (FMV). Once the IPO papers are filed, I'd argue that FMV is within the range outline in the IPO papers. (Something the right CPA could verify) It would be very unusual to file a normal (e.g. NASDAQ) IPO where the IPO price is lower than the current share price. So for example if the last round of venture capital financing was at $5 a few months ago, I'd expect an IPO at $10-$15.

It also starts the clock on the one year holding period, which may or may not be a benefit.

The downside is 6-12 month as you know is an eternity in the internet space, and lots of bad things could happen, and you could end up with nothing more than a big tax bill and worthless shares.

I have not heard of start-up which prohibited employees from exercising stock option during the IPO period. On the other hand it is very common for employees to be prohibited to sell during a lock up period which can stretch up to a year after the IPO for folks at a VP level.

Best case you exercise now 6 months or so later there is an IPO, the lockup period ends around the same time as the year holding period.

There are so many variable, it is hard to give actionable advice. But my best advice is to make friends with somebody in finance. They always have good idea what is going on financially in a company and can help you understand the money aspects of the business. Money spent taking the finance folks to lunch is money well spent IMO.

[Brat]

My daughter works for a VC firm, she rarely comments on those decisions but here are two that I recall: Always sell enough of your holdings to pay your tax bill, watch the CFO like a hawk. Unless the CFO has a serious illness any indication that the chair may get cool is the sign to liquidate.

[Symbiotic]

I was in your situation recently. It's a very complex calculation, even if you correctly identify all the unknowns and are okay with guessing about them.

My naive, original thinking was that I would exercise early and take advantage of LTCG rates. I assumed I would pay up front (AMT) but then get that all back and optimize taxes. However, when I actually used some tax software to run multi-year simulations, the effective tax rate was *considerably* higher than LTCG, even doing everything "right." It was so close, in fact, that the difference ended up being something like 5% in total... and that's with being able to fully apply what remained of the AMT credits in future years, etc. I was shocked at first.

And all of that was before the big downsides, including the capital outlay, the increased tax filing complexity, and the risk that the IPO doesn't go or doesn't go well. (Keep in mind that really good companies -- with strong long-term prospects and who are already cashflow positive, or nearly so -- will defer the offering if the IPO macro-market turns down, and that scenario is basically totally outside of your control.)

I think there are starting conditions that might swing the argument more towards exercising early, like if the spread is small, if the exercise price is small relative to your stash, if you feel a lot of the value isn't priced into the FMV already but will be realized at IPO, if your projected equity in this company is a small(er) percentage of your net worth, if you have the ability to project your income after you've sold most of your stock and it is markedly different (this can interact with how AMT carryforward credits apply), your personal tolerance for risk, and/or probably several more. In my case, many of those things conspired to make it harder for me to justify early-exercise.

Like my situation, I suspect for many others it may be a smarter play to just wait and see, knowing that you'll be somewhat suboptimal on taxes when the cards fall your way.

[obgyn65]

I don't understand this thread but now I know we have very smart and financially savvy people on this Board :-)

[MichaelB]

+1@clifp on the FMV of the option. You can do the math, the difference between the current fair value and the market value after IPO would be taxed at your marginal rate. If that is, say, 25%, you are paying an additional 10% in income tax (25% ordinary income vs 15% cap gain) plus payroll tax. It could be considerable.

OTOH, these are incentive options so you may have to pay AMT when you exercize, and this brings the risk that the shares fall in value and you never recover. Not common, especially at pre-IPO levels, but it is a risk nonetheless.

Regarding a new prohibition on options exercising, that probably can't happen if it is not set as a condition now. They can bar sales in the open market, and they can also fire option holders and recover options (more common with venture capitalists).

[pb4uski]

Sounds like a nice problem to have.

Given all the uncertainties, it might be best to do half and half unless a particular outcome seems likely.

[JBmadera]

I always considered ISO's as "free" money and I would exercise and sell as soon as they vested. I know that folks do it a number of different ways but I have friends/former colleagues that were always trying "max" their potential return and in certain cases (exercise and hold mainly) made a real mess of things. FD - I worked in hi tech from the bubble days so pre-IPO/post-IPO prices were extremely volatile.

[LoneAspen]

I wanted to jump in real quick and THANK everybody for your replies, and the very good info! Definitely some things for me to think about.

I have to dash out the door for now, but will probably post a few more details tonight...after the new Walking Dead and Game of Thrones episodes

Thanks again!

[UtahSkier]

A couple of things. IPO opportunities are rare... and should be maximized. Also, stock profits reward risk taken.

Exercise as many options as you can, as early as you can. If the IPO gets pulled, then maybe the company will be acquired at some later date. The worst that happens is you will have $3000 annual stock loss deduction from income and tax free capital gains until the loss is wiped out.

I wouldn't want to glamorize gambling... but go big or go home!

[RunningBum]

That's actually not the worst thing that can happen. As clifp posted above, you could exercise some shares and incur a tax liability, only to have the bottom fall out. Since you can only offset $3K of capital losses against income, you're stuck with a huge tax bill and scrambling to find a way to pay it.

I remember back in the dotcom bubble burst when some woman allowed her name to be used and described this same type of situation, and said that her plan was to just not report the income from the exercise, and asked what the IRS do? I wonder if she ever found out exactly what the IRS could do, and how much she increased her odds of an audit by publicly announcing her intention to commit tax fraud, as sympathetic as her situation was.

With that in mind, I'd be inclined to wait until you can exercise and sell, and live with the bigger tax hit including AMT. I guess it depends on how much risk you are willing to take, but I'd be willing to reduce my gains somewhat to eliminate the chance of coming out way behind.

[cathy63]

Yes, your company can prohibit you from exercising ISOs during the pre-IPO quiet period. I worked for a company that did exactly this in 2011.

Also, since going public, they've treated all employees as insiders (there are over 2500 employees) and closed the trading window for everyone from one week before the end of the quarter until one day after earnings were announced. Effectively, if you work there, then you and all your immediate family members can only trade the company stock one month out of every three. There was much grumbling about the inability to sell ESPP shares that were acquired during a blackout window, so they finally realigned that program to buy shares one week after earnings were expected to be announced when the window was most likely to be open -- though of course, it can be closed for any reason (that 99% of the employees will not know) at any time.

So yes, if you hold ISOs (or NQSOs for that matter), you may find yourself very restricted in what you can do with them and when, even if that restriction is not documented anywhere today.

[clifp]

Symbotic mentioned running multiyear tax simulation. That was by far best thing my CPA did for me and his highly recommended. (FYI of 30 odds years I've been filing taxes, I've taken pride in always dong my taxes first by hand and then with turbo taxes.) I had to thrown in the towel and use a CPA for the 4 years I was dealing with ISOs. The interaction between the regular tax system and the alternative minimum tax system are so complex that you are better off having two minds and two tax programs look at the problem.

For example Running Bum mentioned the 3K capital loss against ordinary income,you also have to worry about the AMT refundable tax credits, and how increasing your ordinary income vs AMT income, will affect your ability to reclaim this credits.

For good overview of the complexities. I highly recommend reviewing this terrific website Fairmark on taxes for investor. I have not personally purchased their books, (they didn't exist when I needed them :-() but based on knowledge of folks who develop the site and tax professional who hang around the forums. I wouldn't hesitate to buy them.