What’s your IPO lockup expiration strategy?
Working for a company as it goes public can be a very exciting and rewarding experience. If you have stock options, restricted stock awards, or restricted stock units, an IPO means there will soon be a public market for your shares. an IPO makes it much easier to sell your shares 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. However, the downside is that if you exercise early, before the blackout period, your hands are tied if the IPO is delayed or the stock price plummets when it hits the market. Although less common following the recent changes to the tax code, exercising and holding ISOs through the end of the year could trigger the alternative minimum tax (AMT) which may negate the future tax benefits of the early exercise strategy.
If You Quit Before the Lockup Ends
For individuals who plan to leave the company in advance of an anticipated initial public offering or during the lockup period, make sure to read your stock option agreements as you may lose any unvested and/or unexercised shares. If you have incentive stock options, you will generally be able to exercise your shares up to 90 days after your final day with your previous employer. Non-qualified stock options may be more flexible, although you’ll need to 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 your stock options within the predefined window for former employees.
Any time you exercise stock options at a privately held company or in advance of a blackout period there are risks. As we’ll discuss further, if you don’t plan to hold the shares for a full year, there may be little benefit to exercising stock options before the IPO.
Pre-IPO Planning for Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs)
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 acquired or merging with another firm, there are no decisions you’ll need to make regarding your equity compensation.
You’ll need to wait to sell any existing vested shares and new shares that vest during the blackout period until the restrictions are lifted, usually in 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.
If you’re feeling very bullish about the prospects of the company, try to remain as objective as possible about your employer. The stock of any one company is risky compared to a highly diversified mutual fund or ETF that allows investors access to a basket of thousands of companies all at once. 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 R. Ritter at the University of Florida has done extensive research on the IPO market. He found that between 1980 and 2016, IPOs have underperformed other companies of the same size an average of -4.4% after the first year and -8% after the second year. After five years, IPO performance dragged relative to their established counterparts by -3.2% on average.
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 period to end, you’ll need to consider the best course of action once you’re able to finally sell your stock. Developing a plan 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, and so forth to identify potential cash needs, unfunded or underfunded goals, and room for 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 and if you haven’t already, discuss the tax implications with your CPA.
As a financial advisor who frequently works with clients who have stock options, RSUs, and various other forms of equity-based compensation, we have a process in place to help clients through the process, including the steps mentioned above. Please contact us directly to discuss your personal financial situation.
What Not to Do 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 optimal approach for your stock 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 tsunami of new shares that 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. If your finances haven’t materially changed aside from the windfall, buying an expensive new home, car, or boat with the proceeds could have a negative impact on your cash flows and limit 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 have a short-term cash need, there’s probably no good reason to keep a large lump sum in a bank account – especially a checking 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, such as credit card debts, carries punishingly high rates and should be paid off or reduced as soon as it is feasible to do so.
- Taking no action, but not by design. We can’t be experts at everything, and that’s ok. Rather than 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 be repeated. 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.