Whether you work for a company that is pre-IPO or has recently gone public, you may wonder what that means for your stock options or restricted stock units (RSUs). The truth is, there are many different things that can happen to stock options when a company IPOs. Here’s a summary of what can happen to stock options after a company goes public.
What happens to stock options in an IPO?
Employees may wonder what happens to their stock options when their company goes public. An IPO provides liquidity for the company. It’s also an exit strategy for founders/investors and a way for employees to sell stock too.
If you already own stock in a private or pre-IPO company
Assuming you already exercised your stock options, the IPO is probably welcome news. However, keep in mind that there will be a lockup period after the IPO that will prevent insiders (such as employees) from selling their shares. Companies going public with a direct listing bypass the lockup period, meaning employees can sell their stock options right away if they choose.
A lockup period can range from 90 to 180 days. A stock price may also drop when the blackout period expires, as insiders sell shares to get the cash. More on developing a strategy for your shares later in the article.
If you have unvested options or vested unexercised options at a pre-IPO company
Publicly traded stocks listed on an exchange have a clear value, determined by the market each day. They are also typically very liquid. Shares can be sold and redeemed for cash rather quickly.
Private companies work with valuation experts to get a fair market value, which is only done periodically throughout the year. Because of this, it’s less transparent to employees. Unlike public stocks, a private company will decide if/when/how they want to allow employees to liquidate their shares for cash.
Unlike in the case of unvested options in a merger or acquisition, nothing will necessarily happen to your unvested options as a result of the IPO. The exception is that the IPO makes it easier to exercise and sell your shares. There is typically no change to your vesting schedule. Once your shares vest (assuming you are past the lock-up period) you can look at the market price of the stock vs the exercise (or strike) price of your options. This can help you determine if you want to exercise or not. Again, there are tax consequences so it is important to work with your financial advisor and CPA first.
Vested options you haven’t exercised yet
If you have vested options that you haven’t exercised yet, perhaps because of the liquidity issues previously discussed, you will also have choices to make. You’ll first need to look at your strike price relative to the internal valuation of the company. If the exercise price is above or equal to the fair market value (FMV) of the shares, it likely doesn’t make sense to exercise your options.
Depending on what type of stock option you have (ISOs vs NQSOs) and how long you end up holding the shares for, exercising before the IPO could mean you pay less in taxes later. This could happen if the market value of the shares when you exercise before the IPO is less than the value once the stock is publicly traded.
However, it is really important to keep in mind that stock options must be purchased. They can go underwater and you could also suffer a loss instead. IPOs are notoriously volatile. It may help you sleep at night to wait until the company goes public before exercising and selling your shares.
Restricted stock units when a company goes public
Restricted stock units are different than stock options because they don’t require an employee to purchase the shares. Instead, they are given or awarded to employees. RSUs are becoming increasingly popular because they are easier to administer and simplify the process for employees also.
Unlike stock options, which can become underwater if the price you paid is more than the fair market value, RSUs can’t go underwater. They are awarded in terms of number of shares and the value of the shares is the FMV when they vest.
Restricted stock units are given a vesting schedule and upon vesting shares are typically delivered to the employee in the form of common stock. The employee will be taxed at ordinary income rates for the value of the award they received upon vesting. Vesting schedules for RSUs are usually time and event driven.
Many public companies will require time-based vesting but could also include other performance-related requirements, like reaching a target stock price. However, private companies often have a time-based vesting requirement in conjunction with an event-based requirement, such as an IPO, funding, or an acquisition for liquidity.
As seen in the SNAP IPO, RSU-holders also have lock-up periods. The shares may face downward price pressure when the lock-up period expires, as the market anticipates many employees will want to dump their stock.
What to do with stock options after your employer IPOs
If you work for a company while it goes public, it is probably a very exciting time. However, it is important that you remain as objective as possible about your employer and work to develop a plan to liquidate and diversify your equity when the time is right. How much money you should have in your employer’s stock will depend on your net worth and risk tolerance. But in general, no more than 10% of your net worth should be invested in company stock.
Buying single stocks is a risky strategy in general compared to a highly diversified fund or ETF that allows investors access to a basket of thousands of companies all at once. The risk 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, benefits, and so on.
Taxes, liquidity, and cash needs
When you exercise ISOs, it’s not a taxable event, though you may owe tax if you trigger the AMT. But if you exercise non-qualified stock options, the spread is taxed as regular income and any further gain or loss is considered a capital gain/loss depending on your holding period. You’ll also need to come up with the cash to buy the shares.
The point is that when you exercise and hold stock options, you may need another source of cash to pay the tax. Current employees with NSOs will need to work with their employer to satisfy the mandatory withholding requirements and cover payroll tax.
As you consider how best to proceed, be cautious when using your outside (and perhaps more diversified) assets and cash in an effort to hold onto your shares after exercise. Doing so often increases your risk and gives you much less flexibility to fund your other goals. After all, you can’t have your cake and eat it too: to participate in all the future upside you expect means there’s no cash from the after-tax profits to upgrade your home, retire early, or get closer to being financially independent. What’s your end goal?
Luckily, there are ways to diversify out of a concentrated stock position, and the IPO makes it easier. Consider working with a financial advisor who can help you evaluate the trade-offs and develop a strategy for the proceeds. If you expect a large windfall, it may make sense to pull everything together in a financial plan as a big investment in one of your goals (down payment, college, retirement, and so on) may get you there a whole lot faster.
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.
Darrow Wealth Management offers Private Wealth and Asset Management to individuals and families. This article should not be misconstrued as personalized financial, investment, tax or legal advice. Darrow Wealth Management does not provide tax or legal advice; for inquiries regarding your personal tax or employment situation, consult a CPA or employment attorney in your area.