Stock Options And RSUs From Startup To IPO Or M&A: Top Financial Advisors Cover 5 Key Topics
Fast-growing private companies rely heavily on equity compensation to recruit, motivate, and retain the best employees. Grants are typically stock options, restricted stock, or restricted stock units (RSUs). However, stock comp in private companies is surprisingly more complex and varied than what's commonly used in mature public companies. The many challenges of private company stock comp range from the inability to sell stock at exercise for funding the exercise costs to lockup restrictions on shares after the IPO.
A webinar held by myStockOptions.com presented practical guidance and case studies from three financial advisors with expertise in the financial and tax planning for private company equity awards and shares. Discussed in this article are five of the many topics covered.
At private companies in the early stages of growth, stock options predominate. By contrast, in public companies RSUs are more likely to be awarded for new-hire and annual grants. These startup company grants may include what are called "early-exercise stock options," which allow you to buy the stock immediately. At exercise, you receive restricted shares that still must vest before you own the stock. You also have to make a timely 83(b) election with the IRS.
Early exercise comes with advantages and risks. One potential benefit is "the ability to invest in the company early, possibly at a reduced tax cost," as explained by webinar panelist Meredith Johnson, Director of Tax at BPM in San Francisco. "Exercising early converts future appreciation from ordinary income to capital gains and starts the clock toward a long-term holding period," added panelist Devin Blackburn, who at the time was a Senior Vice President at Northern Trust Wealth Management and is now Head of Executive Compensation Advisory at J.P. Morgan Private Bank Advice Lab. Exercising early also starts the holding period for the special 0% tax rate for qualified small business stock (QSBS).
But it's important to note that early exercise is not for everyone. "I usually advise clients to wait to exercise private company stock options until they have to (e.g. changing jobs, options expiring) or possibly for an upcoming liquidity event," said panelist Kristin McKenna, the Managing Director of Darrow Wealth Management in Boston. "Consider the time value of the money that would be used for option exercise—other ways to use that cash and other cash needs until the stock has liquidity." That strategy was echoed by Meredith Johnson: "If there is embedded gain in the private company options, I typically recommend timing the option with a liquidity event (tender offer, etc.)."
As the private company matures and moves toward an IPO or acquisition, equity grants tend to shift toward restricted stock units (RSUs). You don't exercise RSUs, unlike stock options. Once the RSU vesting conditions have been met, the shares are delivered to you.
While RSUs in public companies typically have just one vesting requirement (e.g. length of employment from time of grant), RSUs in private companies have "double-trigger" vesting. In other words, two conditions rather than just one must be met before the RSUs vest and the underlying shares are delivered to you. "Usually time is the first trigger, and an event such as an IPO or a company acquisition is the second and final trigger," explained Meredith Johnson.
Crucially, you cannot control the timing of taxation with RSUs, as you can with stock option exercises. This raises a myriad of tax-planning issues, leading to the next topic.
When you receive stock in a private company, whether by option exercise or RSU vesting, the IRS and the SEC don't care that you can't sell the shares to pay the taxes owed. The same tax rules apply to illiquid private company stock as to freely tradeable public company stock. Therefore, before a stock option exercise or RSU vesting date, you need a way to pay the taxes that you may owe.
With incentive stock options (ISOs), when you exercise and then hold the shares you need to consider the alternative minimum tax (AMT). Plus, while no withholding applies with ISOs, even when you can sell some of the shares, that doesn't mean you may not owe taxes! With nonqualified stock options (NQSOs), you have withholding and taxable compensation income for the spread at exercise, plus Social Security and Medicare taxes (FICA). With double-trigger RSUs, you will face compensation income when all the vested shares are delivered in one batch at the specified time after the second trigger, and then also the FICA taxes when the IPO occurs.
Depending on your tax bracket, the flat federal withholding rate on stock compensation may not be enough to cover the total tax you really owe on the value of the shares you receive. (The rate is 22% for yearly supplemental wage income up to $1 million and 37% for amounts over that.) In this case, you need to think about paying quarterly estimated taxes, making adjustments in your salary withholding, or at least plan to pay extra taxes (and potential penalties and interest) with your tax return for the year.
All of the webinar panelists emphasized that not considering the tax impacts is an especially big mistake with private company stock comp. As Devin Blackburn put it: "lack of planning for the dreaded 'liquidity crush'—you're wealthy on paper but have a persisting cash deficit." You need to think about "how to pay tax without liquidity," Kristin McKenna reiterated.
Some companies, such as Airbnb, Robinhood, and Snowflake, have allowed employees to sell a small percentage of shares at the time of the IPO and/or shares later before the expiration of the lockup. However, in general, you may not be able to sell any shares for up to six months after the IPO date (and often longer with SPACs).
Plus, if you're a company executive or key employee who often knows material nonpublic information, you may also be subject to frequent blackout periods. That is when the company prohibits you from selling stock and thus potentially committing insider trading. That creates the need to consider the use of Rule 10b5-1 trading plans.
This is another planning area where mistakes can easily occur. "Understand the attributes of all your grants, share holdings, the lockup period, and any blackout periods," explained Devin Blackburn. She also emphasized the need to "model various scenarios that reflect multiple price targets to manage expectations and emotions." For example, with unexercised ISOs, when about six months from the IPO, evaluate exercising and holding pre-IPO. Although this may trigger the AMT, after the lockup ends you can then sell the stock, with all the sales proceeds over the exercise price getting taxed as long-term capital gain.
This is the time to tie everything together about your grants and stock holdings. "Calendar the IPO, lockup, sales windows, and tax payments so that you can better coordinate sufficient liquidity to meet your tax obligations," added Meredith Johnson. "Understand the immediate tax impact of an IPO (double-trigger RSUs) and whether there is an opportunity to opt in to alternative tax withholding. Review vesting schedules, early-exercise provisions, and consequences of separation from service." She suggests a goals-based planning model that considers appropriate cash needs to determine a client's sales strategy.
Kristin McKenna recommended that you "use the calendar year to your advantage." This can help you decide whether it's time to take profits and risk off the table, such as selling before year-end, which also avoids any AMT on ISOs exercised early in the year. She also urges her clients to get organized with separate bank account for taxes and cash to exercise, while tracking the lockups' end and any special milestones, such as those related to an acquisition vesting or payout.
There has been a "sheer explosion of IPOs" over the past year, noted Devin Blackburn. "They are up more than 650% compared to a year ago." Like many of their colleagues, the advisors on the webinar panel have been thoroughly battle-tested by guiding clients from the startup stage through the hectic climax of an IPO or acquisition, and then in the newly acquired wealth beyond. "Never assume that someone with a tidal wave of wealth has an adequate team, wealth plan, or estate-planning documents," added Devin. "Founders, employees, and early investors need guidance."
"Client education and communication are particularly important for clients who are unaccustomed to working with professional advisors," observed Meredith Johnson. "Have the uncomfortable discussion about market risk—founders in particular see their stock in a rosy light."
"Recognize that things can change quickly," warned Kristin McKenna. "The market for IPOs and M&A can change rapidly, and stocks don't just go up." She advises her clients to "focus on what you can control." Controllable factors she emphasizes include portfolio diversification to manage the risks of concentration in your company's stock. They also include carefully watching "lifestyle inflation," i.e. the growth of spending with sudden new wealth.
The webinar in which these advisors spoke is available on demand at the myStockOptions Webinar Channel. In addition to what's covered in this article, the advisors addressed numerous advanced topics, such as estate planning, SPAC acquisitions as way to go public, and company-sponsored liquidity sale programs (e.g. tender offers) for later-stage private companies. The sections Pre-IPO and M&A at myStockOptions also cover a range of topics on the financial and tax planning for equity comp in private companies.