What’s your post-IPO stock liquidation strategy?
Working for a company as it goes public can be a very exciting and rewarding experience. If you have company stock, an IPO means there will soon be a public market for your shares. IPOs make it much easier to sell stock options after the lockup period. A lockup period typically lasts six months, and during this time company employees and insiders are unable to sell their shares. While you wait, it’s advisable for equity-owning employees to develop a plan to maximize the value of their stock options or awards through financial and tax planning.
Should You Exercise Stock Options Before or After an IPO?
If you have incentive stock options or non-qualified stock options, you’ll need to decide when to exercise (assuming you’re already vested) or if it even makes sense at all given the current stock price or expectations if you haven’t yet entered the lockup period. Unlike stock awards, options must be purchased (typically through a cashless exercise) which means that there’s a potential for your options to become underwater, meaning the strike price (the price you paid) is greater than the current fair market value of the stock.
Particularly for incentive stock options, which may qualify for more favorable tax treatment, there’s a benefit to starting the clock on your holding period to qualify for more favorable long-term capital gains rates. But the downside of exercising before the blackout is you’re stuck if the IPO pauses or the stock sinks when it hits the market. Exercising and holding ISOs through the end of the year could trigger the alternative minimum tax. The AMT may negate the future tax benefits of the early exercise strategy.
If You Quit Before the Lockup Ends
If you plan to leave the company before the initial public offering or during the lockup period, make sure to read your stock agreements as you may lose any unvested and/or unexercised shares. Employees with incentive stock options can generally exercise up to 90 days after your last day with the company.
Non-qualified stock options may be more flexible, but review the terms as outlined in your company’s equity plan. In either scenario, consider how the timing of the blackout period may impact your ability to exercise options within the window for former employees.
Any time you exercise stock options at a privately held company or in advance of a lockup there are risks. If you don’t plan to hold the shares for a year, there may be little benefit to exercising stock options before the IPO.
Pre-IPO Planning for Restricted Stock Units and Restricted Stock Awards
For employees with RSUs and RSAs, the situation is exceedingly simple. Restricted stock units and awards will continue to vest according to the stated vesting schedule during the lockup period. Unless your company is being bought out by another firm, there are no decisions you’ll need to make regarding your equity compensation.
Existing vested shares and new shares that vest during the blackout period can be sold when the lockup expires, usually six months.
Sell or Keep Stock After Your Employer Goes Public?
Many employees with stock at private companies have a very significant amount of their net worth bottled up in company stock. Until you sell the stock and realize the value, you run the risk the windfall won’t materialize.
Starting to Diversify when the Lockup Ends
It’s normal to feel bullish about the prospects of the company. But try to remain as objective as possible about your employer. The stock of one company is risky relative to the diversification in a fund that owns thousands of companies. The risk of loss is elevated when you’re too heavily invested in your employer’s stock, as you already rely on the success of the business to pay your salary and benefits.
IPOs Have Underperformed In the Short Term
Professor Jay Ritter from the University of Florida is perhaps the preeminent expert in IPO data and trends. His research showed that between 1980 and 2019 IPOs have underperformed other firms of the same size by an average of -2.4% per year during the five years after issuing, excluding the first-day return.
His research also shows average returns over the first six months generally outperformed similarly-sized firms by 1.2%, while performance during months 6-12 typically underperformed by -4.6%. And returns in the first and second years after going public lagged by -3.4% and -7.2%, respectively.
Although employees with very low strike prices relative to the fair market value of the stock will fare better than individuals buying the stock at full price on the open market, it may still not be advantageous to hold the stock if it could be sold and put into diversified investments with less risk and a higher expected return. That’s investing 101!
Developing a Strategy for Stock Options or Awards After the Blackout
As you wait for the lockup to end, develop a plan before you’re able to sell your stock. Developing a strategy for your shares and potential proceeds should involve the following steps:
- Take an in-depth look at your entire financial situation. Gather information about your loans, assets, goals and timeframes, current saving and investment strategy, etc. to identify cash needs, underfunded goals, and investment opportunities.
- Create an Excel file with your vesting schedule to create different scenarios with varying stock prices and proceeds. By having this information in a spreadsheet, you can easily make updates as the stock price fluctuates.
- Consider how your plan may change under various price thresholds. If you haven’t already, discuss the tax implications with your CPA.
As a financial advisor who often works with clients who have stock options and equity compensation, we have a process to help with the analysis. Please contact us directly to discuss your personal financial situation.
What Not to Do with Stock When the Lockup Period Ends
Allocating the potential proceeds between paying down debt, other investments, saving in cash for other goals, lifestyle expenditures, and keeping your positions in company stock is often the hardest yet most important part of the process. Naturally, the prospect of a large windfall is exciting and the lifestyle improvements tempting.
As with nearly everything in life, the best plans often involve a balanced strategy between saving, spending, and investing. The best approach for the proceeds will really depend on your unique personal financial situation and expectation for the future.
With that, there are several mistakes individuals commonly make with their stock when the lockup period ends.
6 Common Post-IPO Mistakes
- Using substantially all the after-tax cash on real estate. Buying a new home, investment property, or aggressively paying down a low-to-moderate interest rate mortgage on a current home are often at the top of the financial wishlist. Though there can certainly be cases made for any of the above, don’t let emotions drive you to enter into a new lockup with your newfound liquidity on illiquid (and often cash-intensive) investments. More on lifestyle spending and good debt below.
- Selling everything at once the first day the lockup ends. Market timing is notoriously tough and usually leads to mixed or disappointing outcomes. Especially for highly publicized IPOs like Uber, Lyft, and Snap, the market closely tracks the blackout period in anticipation of a surge of new shares. This can result in downward price pressure on the stock. Consider a strategy that balances systematically liquidating shares with the pros and cons of waiting for long-term capital gains.
- Locking in high fixed costs on a new lifestyle asset. Have your finances changed, aside from the windfall? If not, buying an expensive new home or car could have a negative impact on your cash flows. It also limits your ability to save in the future. (Who wants to downgrade from a Tesla, anyways?) Simple message: lifestyle inflation can erode your wealth over time, leaving you worse off in the long run.
- Selling and staying in cash for an extended period of time. Unless you need money soon, it likely doesn’t make sense to keep a pile of cash in a bank account. Lacking a plan for reinvestment is a big risk, the opportunity cost can be steep. Consider working with a fee-only wealth advisor to develop a diversified investment strategy.
- Not paying off debt on high interest rate loans OR paying off debt on very low interest loans. Not all debt is equal! Some loans (like mortgages) can offer tax benefits while other debts provide leverage through low interest rates. These debts might actually be worth keeping even if you have the cash to pay them off. Other debt, like credit card debts, carries very high rates and should be paid off/down as soon as it is feasible.
- The do-nothing strategy. We can’t be experts at everything, and that’s ok. Don’t shy away from making a decision if you’re unsure of how to manage your stock; engage a professional to help.
Before mentally pre-spending your proceeds, keep in mind that sizable windfalls from a company going public don’t happen every day. You are likely on the cusp of a major financial milestone in your life – one that might not repeat itself. That isn’t to say that you cannot – or should not – do something enjoyable with the proceeds. But try to strike a balance between your current and future wants and needs.
Employer going public? We can help.
Darrow Wealth Management is a fee-only financial advisory firm. We regularly work with employees and executives with stock options, particularly after an IPO or acquisition. By integrating financial planning with investment management, our goal is to help busy professionals build and grow their wealth. As an independent full-time fiduciary, we have a duty to act in the sole benefit and interest of our clients. This is the highest act of loyalty, trust, and care under the law.