Pre IPO Stock Options

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Contents

    If you’re an employee who has common stock options as a component of your company’s employee comp plan, there are some basic things you need to know about them before you decide whether to exercise them.

    First off, if you’re reading this because you’ve received an email about your employer offering you the chance to buy shares in your company beyond your ordinary income, then congratulations! You may already own some employee shares in your company through your employment contract. If not, then you should definitely consider buying them before they go into full effect. Buying shares in your company could be a great way to build wealth. Remember to make sure you have a plan in mind for how you’ll sell your shares once you receive them.

    Consider these factors carefully before deciding whether to take action. If you act improperly, you might end up reducing the amount of your inheritance.

    When planning to buy shares, one should consider what kind of investment they are buying. Are they buying an individual share, or do they own part of a business? How much money are they willing to invest? What happens if they sell their shares before the price goes up? These are just some of the things that should be considered when purchasing stocks.

    What are pre-IPO incentive stock options (ISOs)?

    If you’re going to be exercising your incentive stocks, you need to know their current value. Even if you’re not planning to sell them immediately, having a baseline value helps you decide whether an investment makes sense for you.

    Similar to Pre-IPO shares, Pre-IPO stocks don’t trade on an open market. Therefore, their prices aren’t readily definable. Unlike Public Company Stock, If you decide to buy pre-IPO, then the estimated valuation of the stock you’re buying is likely based on the last estimate of your company’s fair market price, which is determined periodically.

    If you want to know whether your investment was a good one, you’ll probably need to look at the company’s performance after the IPO.

    After exercising your stock options, you will own stocks in your business. While these stocks have some similarities with stocks of publicly traded companies, they also differ from them in several ways. These differences are discussed below.

    The effect of long-ter­m Capital Gains Tax

    You first have a choice between two options:

    You should wait until after the initial public offering (IPO) before exercising your stock option plan and paying ~50% in taxes when you sell your shares.

    OR

    Exercise your stock options early in order to avoid paying 35% tax on them.

    Long term capital gain refers to income from assets held for at least one year.

    If you’re exercising an option right before the IPO, you can get some tax benefits from doing so, depending on the exercise price and lockup period.

    What if exercise is too expensive?

    If you’re an early-employer, the exercise tax rate bill and exercise price could be quite high.

    If this makes Stock Option Exercises financially impossible for you, you can exercise options until the amount you’re comfortable investing in them has been reached. So, you still get partial benefits from long-term capital gain.

    If you’re able to afford it, you could use both the stock market and the crowdfunding platform for funding your retirement.

    Developing your exercise strategy

    For those who hold ISOs or non-qualified stock option (NQSO) plans, exercising them early after the lockup period can save money later. Stock option holders can defer taxes on income earned through exercises until they sell the shares. Exercising an ISO before two years from the date of issue allows investors to avoid paying taxes on the profits. NQSOs also allow investors to defer taxes on income earned during the life of the plan.

    When to sell and when to hold out for better prices

    If you’re worried about FOMO when deciding whether to sell your shares at their initial public offering price, think about reducing your exposure by buying back some of your own shares instead at the current share price on the Public Market.

    It’s important to keep an eye out for any signs of irrational exuberance among employees of pre-IPO companies and new public companies. However, shareholders of publicly traded companies may not be as understanding if profits aren’t met.

    It’s important to consider whether to hold or sell shares when the lockup period expires. If you received a cash bonus, would it be used to purchase more shares?

    You need to plan for both financial and tax implications when deciding whether to exercise your stock options.

    Some trade-offs and considerations:

    Don’t get caught up in the details. The important thing is to keep enough money aside so that you can live comfortably without worrying about taxes. You’ll find that if you take care of yourself, the government will take care of itself.

    If more than 10% of an investor’s total net worth is invested in any single security, that’s considered a concentrated portfolio. On the contrary, diversified portfolios can reduce risks on several different fronts.

    Don’t be unrealistic about risks associated with investing in biotech and pharmaceutical companies. Particularly if they’re highly volatile (like biopharma).

    How have IPOs performed?

    Professor Jay Ritter, who is considered one of the most prominent experts in IPO analysis, has found that IPOs underperform their peers by an average of 2 percentage points annually for the next five years, excluding the first day returns which can be quite large.

    He found that, on average, initial stock price gains were better than expected, but subsequent losses were worse than expected.

    To be clear: IPO’s can be wildly successful. However, we make the points above so that employees who own stock will understand why they should not be too optimistic about the company’s future performance. In finance and investment, the best strategies often fall somewhere between extremes. That means that rather than focusing on one approach, investors should consider a range of options and then choose what works best for them. In other words, it’s not an either/or choice when thinking about how to handle your employee stock plans after the lockups expire. Rather, the best option may involve developing a strategy where you buy and sell stocks over a certain amount of money over a given period of months.

    Lessons learned from Recent IPOs

    “There has been a sheer boom in IPOs.” Over the last year, they’ve seen a 650 percent increase in the number of companies going public. Many of them have been guided through the IPO process by their advisor teams. They know that founders, early investors, and even current staff members need help navigating the new world of wealth.

    Client education and communication are especially important for clients who are unfamiliar with working with professionals. Have the uncomfortable conversation about financial risks—especially for entrepreneurs—and explain why they may be necessary.

    Recognizing that markets can shift quickly, Kristin McKenna warns her clients to focus on what they can control, which includes diversifying their portfolios so they aren’t overly concentrated in one sector or asset class. They also need to watch out for lifestyle inflation, i.e. the growing costs associated with having suddenly acquired wealth.

    Conclusion

    Contact your employer’s Human Resource Department for the stock options agreement, which is also referred to as a stock option agreement (or an employment contract).

    Make sure you read through these documents carefully. They include important details such as when you’re eligible to receive your stock options and what would happen if you leave the job.

    If you were fired without notice, you would likely lose any stock options you had been granted. But if you were given notice before termination, you might be able to exercise them within a certain time frame.

    Understanding likely next steps for your business will help you decide whether you want to be part of a start-up or not.

    We recommend speaking to financial advisors to guide you on the best way forward. Considered financial planning often gives you clarity on the best way forward.

    Dylan Morwell

    Since becoming an Accredited Investor himself, Dylan Morwell has had a fascination with accredited investment and loves to help others achieve the same success.

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