Stock options and IPO planning

[orangehairfella]

I was granted a significant number of ISO shares at a job years ago and was able to hold on to them post separation. Through the grapevine I've learned that the company is prepping for an IPO in the next 6-9 months. After the IPO I'd be subject to a 6 month lockup. My goal is to get rid of these and diversify.

My cost to exercise would be about $50k, and the profit, assuming the FMV stays stable and the stock doesn't "pop" would be about $500k, less taxes.

Pretending I can sells in 12 months (6mo to IPO + 6mo lockup), I could:

1) Exercise now by paying the $50k. I would be subject to AMT on the $500k, which is, well, a lot. For the next 11mo I'm out $50k and come April of next year $140k would be due in AMT. I'd be able to cover that with the sale soon after.

Questions: How does AMT play with long term capital gains in this situation? Does the 15% LTCG rate even apply since I'll have already paid 28% in AMT? We're assuming that the stock stay flat and that there's no additional gain over the bargain element. If I'm paying 28% already perhaps plan 2 makes more sense? The post tax with AMT is $360k, with LTCG its closer to $420k. My understanding is that I can recoup some of that AMT in later years, but it may take a decade+, and I'm effective getting a 0% return on that money in the mean time.

Risk: The IPO may delayed or even canceled. Delayed seems very possible knowing the process. I'm out the $190k from my portfolio until the IPO happens, the lockup expires and I can sell, thus its earning nothing in the meantime. I consider the cancellation risk low, but non-zero, I'd be out $190k possibly forever.

2) Hold the options, exercise and sell in a "single" transaction after the IPO. Gains would be taxed as regular income, netting me ~$300k. Little/no AMT hit since this taxed as regular income. This allows me to keep $190k invested and continuing to earn over the next 12 months.

Questions: This hinges on the above I suppose. $300k vs $360k is good chunk, but that additional $60k between $300k and $420k feels huge.

Risk: 100% change of leaving between $60k and $120k on the table, depending on how the AMT thing plays out. 0% chance of losing $190k.

3) Hold the options until IPO. Wait 12 months for LTCG. This way I know the stock will be worth something. Here again I'm out 50k for 11mo, and $140K for at least a short while depending on the difference between tax day and the 1 year anniversary of the IPO.

Risk: I have to wait an additional 6mo to get to LTCG after the lockup expires. The stock could drop, and this is common, very common, amongst newly public companies as institutional investors sell in an attempt to realize "pop" profits or mitigate losses.

4) Hold until IPO, sell after lockup expires. I see no upside here, this is the same as #2 except I'm out the exercise cost for 6mo, depending on timing I may still get hit with AMT and I still have to pay regular income tax when I sell, less AMT credit, I think?

Did I miss any scenarios? Is my understanding of the situation correct? Close? Way off?

 

[cathy63]

I think you are missing the scenario where the stock takes a dive immediately after the IPO. That's what happened with both of the companies where I had ISOs. (DH did much better than that though.) Just because there's a 6-month lockup doesn't mean the price will be stable during that period, and I can tell you from personal experience that it's incredibly frustrating to be in that window and unable to make a move when you're not even an insider any more. You may think that there's no way the stock could fall so far that you'd be underwater while you are prohibited from selling, but there are many, many people to whom that exact thing has happened.

With scenario 1, I don't think there are LTCGs to consider. If you pay income tax (AMT in this case) on the difference between the exercise price and the FMV of the stock when you exercise, and then it stays flat until you sell it, then your basis equals the sale price so there's no gain. LTCGs only come into play if the price goes up. Also, I really would not count on recouping much of that AMT in later years if you are going to continue working. You're in an industry where you have ISOs, so you're likely already highly compensated and subject to AMT on your regular earnings in most years anyway.

For scenario 2, have you run that through a tax program? You say there's little to no AMT on that, but I'm not sure you can have $300K of regular income and not get hit with AMT. This is certainly the safest choice in the event that the stock does tank. You might be leaving money on the table, but you are also mitigating the risk from scenario 1 where you pay taxes on $500K but it turns out to only be worth $100K by the time you can sell.

One other thing you might look at is doing a same-day sale of some shares and a buy-and-hold on the rest. You would want to net enough on the same-day sale to cover the taxes on the shares you're holding. I've never done this with ISOs, but I don't see why you couldn't. We did do it several times with NQSOs and RSUs, and while it might not have made us the most profit, I definitely slept better at night knowing we were gambling with company money.

 

[orangehairfella]

I suspect you're right. I entertained the possibility of a drop in #3, but it absolutely applies to any situation in which I exercise and hold for any amount of time.

Figuring AMT vs regular income brings the spread to only about $50k. Its hard to put nearly $200k into limbo over a very risky $50k. Even if the stock did well, the difference just isn't very big, at least not worth risking my own $200k.

I did run #2 through tax software. AMT comes into play, but my deductions are minimal and a $500k + salary year would put me deep into the 39.6% bracket, so my regular income tax should exceed AMT by a good bit. I'll almost certainly stick with Scenario 2 with its low risk and, relatively, small fixed penalty.

 

[Dash man]

When taxed as ordinary income you'll also have to pay the Medicare tax and SS tax if you hadn't already maxed it out. State and local tax agencies will also want their share.

 

[FiveDriver]

Without giving away too much info, can you say if this is in a "growth" industry ?? Is there a chance that this stock behaves like Facebook. A number of folks got frustrated when the stock dropped right after the IPO and sold low (they probably cringe when they look at that chart now).

 

[orangehairfella]

When taxed as ordinary income you'll also have to pay the Medicare tax and SS tax if you hadn't already maxed it out. State and local tax agencies will also want their share.

Fortunately maxed, but thats a good point on state taxes. Obviously that depends on the state, and how they treat income vs capital gains on a state level, but definitely something to consider.

 

[orangehairfella]

Without giving away too much info, can you say if this is in a "growth" industry ?? Is there a chance that this stock behaves like Facebook. A number of folks got frustrated when the stock dropped right after the IPO and sold low (they probably cringe when they look at that chart now).

If I was smart enough to know if/when any random stock was going to drop 50% immediately, and then proceed to gain 50%+ per year every year, I would already be retired!

 

[Blue Collar Guy]

yup im a loser

reading these posts about a half of million dollar stock options, when i just finished a post that said i made 275 a week and ended at 961 a week shows in im way out of my league in here. God bless you, i was all happy i saved a few dollars and have a paid off house, now ill go take a walk on park avenue, look at a few Maybachs and really want to commit suicide, . I did well in school, i listened to the teachers , i went to the Army, i fear God, where did i go wrong? i think ill stick to talking about splurging on real maple syrup, obviously finance is not my strong suit, . But im very happy for all of those that achieved this, i missed the boat of this level of financial success.

 

[brett]

You should base your decision on financials and risk.

Don't base you decision only income tax consequences. I know several people who missed substantial SO gains simply by delaying because of taxation issues. They paid no attention to risk and sound financial decision making.

Had I listened to the so called experts at work who said the stock was going to $75. I would probably still be working and have a pile of worthless SO certificates to paper my walls. I cashed in at 43-54. Stock went to 55, then down to 15.....just slightly below water for the majority of the options. So glad that I did not listen to the wags at work.

 

[Rambler]

Wait until IPO, exercise and sell. IMHO, in a pre-ipo situation there is too much risk ($190) because any number of things could happen before you are able to sell, including total loss of the $190k. Then, once you exercise and sell, you can wait 31 days and buy back a small portion of that stock, should you wish to hold some of it (or exercise and sell the bulk, and exercise and hold a small portion, using the proceeds of the sold portion to pay for the hold portion). The most important thing is that you diversify as quickly as possible after any lockup. $500k in a single stock is too much unless you are worth $10M otherwise. Be careful about getting greedy. I once waited, in 2007, for a small drop to correct, before selling and holding. It never corrected to the point it was at, before my options expired. I still kick myself every time I think about not exercising and selling those options when they were worth $3M pre-tax...1.5M post tax. OUCH!

 

[orangehairfella]

I suppose another tick against any LTCG optimization of a $500k transaction, although we've established it doesn't really come into play in this scenario, is the ACA's 3.8% tax on large capital gains distributions bringing the rate to 18.8% for much instead of 15%.

It might only be another $10k in taxes, but its another point in favor of cashless exercise and sell for anyone who finds this thread later.

 

[audreyh1]

I bought qualified options pre-IPO, paid the AMT - I don't think it was much due to the AMT exemptions, and several of us got together to have an accountant document value the private stock at something not too outrageous. The option exercise price was quite small so my initial cash investment was low. Had to wait 4-5 more years for the IPO to finally happen - it was just funny money until then. By IPO time the cap gains on the stock was huge. I held on to most of it for several more years, then gradually started divesting as I built our retirement portfolio. I think I waited until the LTCG rate dropped from 28% to 20% - wasn't much incentive to sell and pay 28%.

Needless to say the company didn't crash and burn at the IPO. But it was volatile for the first many years, would more then double, then get cut in half. Seemed to repeat every couple of years - just like many tech stocks, a roller coaster. I would sell a little at the peaks, then wait through the troughs. The company did not get slammed in 2000, even though it was a tech company, probably because it didn't have an insane run up in 1999 either.

For a very long time >95% of my net worth was tied up in that company stock. But that's also how I retired at 39.

 

[bingybear]

I suppose another tick against any LTCG optimization of a $500k transaction, although we've established it doesn't really come into play in this scenario, is the ACA's 3.8% tax on large capital gains distributions bringing the rate to 18.8% for much instead of 15%.

It might only be another $10k in taxes, but its another point in favor of cashless exercise and sell for anyone who finds this thread later.

Doesn't exercising start the clock for LTCG? Plus if you are selling 500k, it would not be at 15%.

 

[ulrichw]

I was granted a significant number of ISO shares at a job years ago and was able to hold on to them post separation. [..]

I'd like to question a few of your assumption (not saying they're wrong, but just make sure that you're right about them):
1. How did you determine your fair market value? Your options are likely for common shares, which are not the same as the preferred shares investors get. Unless you know someone who recently received stock options at the notional value you're using, your fair market value may be much lower.
2. Are you sure the lockup applies to you? It is not unusual in my (admittedly limited) experience for non-employees not to be subjected to the same rules as employees.

If your fair market value is still low, now would be a good time to exercise to avoid a large AMT hit post-IPO. Beware that the valuation of common shares typically gets ramped up in the months preceding IPO, so it's a case of sooner the better here.

Don't understimate the risk of AMT.

I'll tell you a brief story of a startup I was involved with around the dot com bust: Our marketing VP ended up exercising all his shares when we were acquired (it was a stock-for-stock deal). During the six month lockout period the stock of the company that acquired us went from $60 to $6 (the resulting valuation was probably a more accurate representation of our worth to them, but that's another story).
The IRS, unfortunately, doesn't care about this. He owed AMT on the notional gain when the transaction happened. The actual gain he had at the end of the period wasn't nearly enough to cover the AMT amount. From what I heard, he had to take out a second mortgage to cover what he owed.

This is pretty much a worst case example, but it's wise to make sure you're protecting yourself as well as you can. A strategy to cover the risk is to do your strategy #2, but sell only part of your shares (at least enough to cover your AMT).

Hold the rest for the tax advantage. This requires some faith in the performance of the company, of course. (Even though you generally don't want to use the tax rate to dictate investing strategy, in this case, the 20% or so difference makes it a bigger factor than it typically is)

 

[Texas Proud]

Does the lock out period prevent you from buying put options to protect the downside

 

[kcowan]

So glad that I did not listen to the wags at work.

Yes me too. Not only re company stock but other investment fads being promoted by various advisors.. I would always look for ways to take the other side of the sheep investors.

I was especially averse to investments encouraged by governments, like labour-sponsored funds.

 

[brett]

The best financial and career actions that I took were just about always counter to what the wags advised.

I know a number of folks who are very sorry they accepted a DB buy out/ switch to DC plan. Interest rates were high at the time, the buyout number was therefore low. They listened to the know it all wags at work without doing any analysis on their own situation.

 

[Dash man]

Does the lock out period prevent you from buying put options to protect the downside

It may result in a lock up....in jail.

 

[Texas Proud]

It may result in a lock up....in jail.

Any info on this?

The reason I asked is I was in a seminar where they were talking about protecting the downside of options that have good growth but are not yet able to be exercised with puts... I wondered if they could do it and they seemed to be saying yes...

So, is there law against a put on a lock out period or not?


To add... found this while looking... does not seem to be against the law!!!


The Securities and Exchange Commission does not require companies that are going public to have a lock-up period. Rather, the lock-up period is something that the companies themselves and/or the investment banks underwriting the IPO request to keep the stock's price up.

 

[Dash man]

Lock up periods are typically used to prevent employees with knowledge of proprietary information that is not generally known to the public from trading on their proprietary knowledge for thirty days before an earnings announcement...also known as insider trading and very illegal. However, that applies regarding options to stock that is already public. Pre-IPO stock does does not have the ability to trade options for several weeks after the stock goes public. So the lock up period is company imposed primarily to stabilize stock value and aid in setting the IPO price.

 

[Texas Proud]

Lock up periods are typically used to prevent employees with knowledge of proprietary information that is not generally known to the public from trading on their proprietary knowledge for thirty days before an earnings announcement...also known as insider trading and very illegal. However, that applies regarding options to stock that is already public. Pre-IPO stock does does not have the ability to trade options for several weeks after the stock goes public. So the lock up period is company imposed primarily to stabilize stock value and aid in setting the IPO price.

I know it is illegal to trade if you have insider info... but the thread was not about that...

So, since we were talking about IPOs for someone who does not work there anymore and we assume has no insider info.... what are his options... and he is talking a year where they say he cannot trade his shares... if it is only a few weeks until options are available, then he still can protect his holdings with options for the remainder of the year...

 

[cathy63]

I know it is illegal to trade if you have insider info... but the thread was not about that...

So, since we were talking about IPOs for someone who does not work there anymore and we assume has no insider info.... what are his options... and he is talking a year where they say he cannot trade his shares... if it is only a few weeks until options are available, then he still can protect his holdings with options for the remainder of the year...

It's only 6 months where he can't trade his shares. He could trade after 6 months, but if exercised at or before the IPO, he wouldn't have held them long enough to qualify for LTCG treatment on the gains.

He will have to read the plan documents that came with the options grant and any severance/termination paperwork he signed to find out what he can do with regards to trading the company stock or puts during the lockup period. Typically if you are subject to a lockup, you have signed something that says you understand you cannot trade the company's stock or any future interests in company stock during that time.

If caught, it's not that you are in violation of any law (assuming it's not insider trading), but you are in violation of the terms and conditions under which the stock was granted to you, and your options can be revoked.

 

[kcowan]

The best financial and career actions that I took were just about always counter to what the wags advised.

I know a number of folks who are very sorry they accepted a DB buy out/ switch to DC plan. Interest rates were high at the time, the buyout number was therefore low. They listened to the know it all wags at work without doing any analysis on their own situation.

Yes I ran the numbers and accepted the immediate payout of a reduced DB plan. One of the very few. Subsequent offers did not even include that option so I assume the numbers guys changed their discount rate assumptions to something like what I had used.

 

[petershk]

I think without considering the complete financial picture it's hard to answer.

About 5 years ago it became clear to me that my ISOs that I assumed would be worthless (as they always were before) would potentially be worth a lot. By a lot mean about 30x my then net worth.

The liquidity strategy was murkey though. So I had a cost basis of a few pennies and a FMV of around $30. If I exercised and held the taxes would be most of my net worth so there's no way I would do that.

My operating thoughts are don't risk what you need to get what you don't.

So I waited until the liquidity event was obvious expecting that even if I paid income taxes (turning ISO into NSOs basically) it was more money than I needed to retire. If I had bought the ISOs and held it would have saved me TONS of taxes but if there has been no liquidity or an IPO crash I would have been kind of wiped out. So... I overpaid taxes, and protected my savings.

If I had 30x my net worth and the ISOs were more like 20% of TNW I certainly would have exercised and held.

I plan more or less for worst case... I lose some upside but that's ok because I protect the downside and rest easily knowing I avoided disaster as much as possible.