If you’re an employee at a pre-IPO tech company that is about to go public or have its IPO, this liquidity event matters to you because it means you will be able to sell your employee equity and get rewarded for all of your hard work. Congrats! When your company goes public or has its Initial Public Offering (IPO), you can sell your shares in your company in the stock market.
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What to do when your company IPOs
This post will walk you through the steps you need to take to make sure you make the most of your employee equity when your company IPOs. Your employee equity may include Incentive Stock Options (ISOs), Nonqualified Stock Options (NSOs), and Restricted Stock Units (RSUs).
As a financial planner that specializes in helping tech professionals at pre-IPO companies make the most of their employee equity, I’ve helped guide my clients through dozens of IPOs.
When can you sell your employee equity?
First, you want to understand when you can sell your employee equity. This typically depends primarily on what way your company goes public. The way your company goes public determines the length of the lock-up period.
The lock-up period means that employees and insiders are not allowed to sell their stock during that time. The primary purpose of the lock-up period is to make sure that insiders and employees don’t flood the market with lots of shares and push down the stock price initially. For you, the lock-up period matters because you typically can’t sell your shares until the lock-up period ends.
The traditional IPO typically has a six-month lock-up period. This means if your company had its IPO today, you wouldn’t be able to sell any shares until six months from today.
Traditional IPO with Early Releases:
Another type of IPO includes the traditional IPO with early releases. This means your company allows you to sell a certain percentage of your vested equity at specific times during the lock-up period.
For example, if your company had its IPO today, your company may allow you to sell up to 25% of your vested equity in the first two weeks from today. They may also allow you to sell 15% more of your vested equity 90 days after the IPO date as long as certain business targets are met. Then you can sell 100% of your vested equity 180 days or six months when the lock-up period expires.
The specific details including the percentages and timing vary by company
A direct listing is another way for companies to raise capital and sell shares that is different from an IPO. In a direct listing, companies sell their shares directly to the public without the help of any underwriters. Companies choose this way for various reasons, but this method is less common than a traditional IPO.
The most important thing to understand with a direct listing is that there is no lock-up period, and your company typically allows you to sell your vested equity immediately!
For example, if your company had its direct listing today, you can sell 100% of your vested equity today.
Special Purpose Acquisition Company (SPAC):
Another way to raise capital that has become much more popular in recent times is the Special Purpose Acquisition Company (SPAC), also called a “blank check company.”
A SPAC is a shell company that exists only on paper and goes through the traditional IPO process to become a publicly traded company. The company is an investment entity that merges with a private company. That merger turns the private company into a public company.
A SPAC typically has a longer lock-up period of six months to one year which means your company allows you to sell your vested equity six months to one year after the merger date.
These are the most common ways to go public and their typical lock-up periods, but the specific details of the lock-up period vary by company.
Your company should provide details on your lock-up period, or you should ask for that information. This will help you answer the first important question if your company is having an IPO: When can you sell your employee equity? You should also recognize that you may have a window of opportunity before the IPO happens to save on taxes.
For example, one potential way I help clients minimize taxes is by having them exercise stock options before their company’s IPO date if they have high confidence that the stock price will increase significantly after the IPO.
|Going Public Type||Selling Vested Equity Timing|
|Traditional IPO||Can sell 100% after 180 days|
|Traditional IPO with Early Releases||Can sell % at specific times, e.g. 25% first 14 days, 15% after 90 days, 100% after 100 days|
|Direct Listing||Can sell 100% immediately|
|SPAC||Can sell 100% after 6-12 months|
Pre-IPO Employee Stock Options and RSUs: What type of employee equity do you have?
The next step is for you to understand what type of employee equity you own.
The most common types of equity are Incentive Stock Options (ISOs), Nonqualified Stock Options (NSOs) and Restricted Stock Units (RSUs). The primary reason you want to understand what type you own is because the tax treatment for each type is different. If you understand how the taxes for each type of equity works, you can minimize the taxes you pay when you sell your equity.
INCENTIVE STOCK OPTIONS (ISOS)
ISOs are options which means that when you own your ISOs, you have the right but not the obligation to buy shares.
ISOs come with an important tax benefit that isn’t available with other types of employee equity which I’ll explain later in this section. The way Incentive Stock Options typically work is that you are granted a certain number of ISOs when you start to work at a private company. These ISOs have an exercise price which is set when your ISOs are granted. You vest or earn ownership of these ISOs over time depending on your vesting schedule.
For example, your vesting schedule may have you vest 25% of your ISOs after your first year at the company, and the remaining 75% will vest on a monthly basis over the next three years. After you vest your ISOs, you can choose to exercise them, pay the exercise price, and you will own those shares.
The important tax benefit that makes ISOs different from other types of equity is that you pay $0 in ordinary income tax when you exercise them. This is great news! However, you may have to pay Alternative Minimum Tax (AMT) when you exercise your ISOs. You should get help from a tax professional to understand if you need to pay AMT since this depends on your specific tax situation.
The key benefit of paying $0 in ordinary income tax when you exercise your ISOs comes if you exercise and hold ISOs for more than one year and more than two years after your grant date. This means your ISOs qualify for the lower long-term capital gains tax rate vs. the ordinary income tax rate on the difference between your exercise price and the fair market value.
For example, the highest Federal ordinary income tax rate is currently 37% compared to the highest Federal long-term capital gains tax rate which is currently 20%. In this example, you could save 17% in taxes on your gain if it qualifies for the lower long-term capital gains tax rate. If you have $1M in gains, you could save $170,000 in taxes!
The key takeaway for you is that if you own ISOs, you have a huge opportunity to save on taxes.
For example, one common strategy I use with my clients is to exercise and hold enough ISOs to get their income to the point just before AMT kicks in which enables them to start the clock on qualifying those ISOs for the lower long-term capital gains tax rate, but pay $0 in AMT.
Since the best way to minimize taxes depends on your specific situation, you should talk to a tax professional or financial planner who understands how ISOs work.
NONQUALIFIED STOCK OPTIONS (NSOS)
NSOs are similar to ISOs in that when you own your ISOs, you have the right but not the obligation to buy shares. Similar to ISOs, you also pay $0 in ordinary income tax when granted and vested. However, the key difference from ISOs is that when you exercise your NSOs, you have to pay the ordinary income tax rate on the difference or spread between the exercise price and the fair market value.
NSOs derive value from two sources:
- Intrinsic Value – Intrinsic value is the difference between the exercise price and the fair market value and is the value most people think about.
- Time Value – The time value is the potential for more profit based on the time until the option expires. Most NSOs have an expiration period of 7-10 years. If you own that NSO and are still working at the same company, you have 7-10 years to exercise that option. After an option expires, you can’t exercise it because the option is gone. The easiest way to illustrate the time value of an NSO is to ask you the question: Would you rather have NSOs that expire tomorrow or 10 years from today? Most people would choose the NSOs that expire 10 years from today because they have a better chance to increase in value over the next 10 years vs. by tomorrow.
In general, given that you have to pay ordinary income taxes as soon as you exercise your NSOs, and there is time value in your NSOs, you should consider holding them as long as you can and exercising when you get within ~1-2 years from your expiration date unless you have valid reasons for exercising earlier.
For example, one method I use to help my clients manage this situation is to set up a schedule to exercise their NSOs whenever the NSOs get within <2 years from their expiration date.
Again, this will depend on your specific tax situation which means you should talk to your tax professional or financial planner to figure out the best way for you minimize taxes.
RESTRICTED STOCK UNITS (RSUS)
RSUs are compensation in the form of company stock that vests over time.
ISOs and NSOs give you the option buy stock, but you don’t have to buy it. However, with RSUs, you own the stock as soon as you vest.
You pay $0 in ordinary income when you are granted RSUs which is the same as ISOs and NSOs. However, you pay the ordinary income tax rate on the fair market value of the stock when you vest which is different than ISOs and NSOs.
RSUs issued by pre-IPO companies are often what are commonly called double-trigger RSUs. This means that two triggers or specific events need to happen before you own and pay taxes on your RSUs. Typically, you need to both:
- Vest your RSUs based on your vesting schedule
- Your company needs to have a liquidity event such as an IPO.
After both of these events occur, you own the RSUs and need to pay taxes on those RSUs.
For example, if you’ve vested 25% of your RSUs and your company IPOs, both triggers have occurred, and you now own 25% of your RSUs. In this example, you would need to pay the ordinary income tax rate on the fair market value of the 25% of your RSUs that you own.
I suggest my clients view RSUs as a cash bonus in the form of company stock because you get taxed immediately when you vest vs. paying $0 when you vest ISOs or NSOs.
One way to illustrate this is to think about two versions of getting stock:
- In the RSU Version, assume you vest $100,000 in RSUS. The company sells enough RSUs to cover your taxes and other withholdings. Assume the company sells $40,000 of RSUs to cover your taxes, you are left with $60,000 in company stock.
- In the Cash Bonus Version, assume you get a cash bonus of $100,000. The company withholds from your bonus to cover your taxes and other withholdings. Assume the company withholds $40,000, you are left with $60,000 in cash. You can take your $60,000 and go buy $60,000 of company stock (this assumes your company is publicly traded at this time). You are left with $60,000 in company stock which is exactly the same place as the RSU Version.
If you choose to hold your RSUs, it’s exactly the same as buying the stock at the current price. The question I ask my clients and you should ask yourself is: If your company gave you a cash bonus today, would the first thing you do with that cash be to buy your company stock? If you answer no, you should consider selling your RSUs.
In general, given that you pay taxes on RSUs as soon as you vest, I suggest you seriously consider selling immediately.
As always, you should check with your tax professional or financial planner since this decision depends on your specific situation.
Do you have too much employee equity?
I talk to all of my clients about, and you should understand the concept of, a concentrated stock position, which is owning too much of a single company stock or employee equity.
My general guideline is that if you have > ~20% of your investable assets in a single company stock, you own a concentrated stock position and are highly concentrated. You should be concerned about being highly concentrated because it means you’re taking on a ton more risk and volatility vs. when you hold a diversified portfolio.
This risk is captured in the story of Enron which was a high-flying energy company in the early 2000s. The stock skyrocketed for years up to more than $90/share in mid-2000 until news about an accounting scandal broke and the stock plummeted to less than $1/share by November of 2001.
Unfortunately, some employees had most of their 401ks in Enron stock since contributions could be invested in company stock, and 401k matches were made in company stock. These employees lost hundreds of thousands of dollars of their retirement savings because they were too highly concentrated in Enron.
How to calculate your employee equity concentration
You should understand how concentrated you are in your employee equity. Follow these simple steps to calculate your employee equity concentration.
Step 1. Calculate the total value of your vested employee equity including ISOs, NSOs, and RSUs. Use your company’s most recent per share valuation.
Example: You have $4,000 vested RSUs in company stock and the current per-share valuation is $100. That means that you have $400,000 in vested company stock.
Step 2. Calculate the total value of your investable assets.
This includes assets such as savings accounts, brokerage accounts, investment accounts, stocks, bonds, mutual funds, retirement accounts, 401ks, IRAs, and Roths. You should also include the value of your vested employee equity. This does not include assets that are not highly liquid such as the equity in your house or other real estate.
Example: You add up the values of your savings accounts, brokerage accounts, and 401ks and calculate that you have a total value of $600,000. You add this $600,000 to the $400,000 value of employee equity and you have $1,000,000 in the total value of investable assets.
Step 3. Take the total value of your vested employee equity and divide it by the total value of your investable assets to get a percentage.
This percentage represents your concentration. If that percentage is greater than 20 percent, then you are highly concentrated and should keep reading to understand how to reduce your concentration.
Example: You take your $400,000 of the total value of vested employee equity and divide it by your $1,000,000 of the total value of investable assets to calculate that you are 40 percent concentrated in your employee equity. Since 40 percent is more than the 20 percent threshold, you are highly concentrated and should keep reading to understand how to reduce your concentration.
When should you sell your employee equity?
Here’s one approach to deciding when to sell your employee equity that I use with my clients.
Step 1. Identify any valid short-term financial needs, with short-term being defined as less than ~1-2 years.
Examples of these types of needs could include paying taxes on your employee equity, building an emergency fund, or funding a down payment. These are needs that you know you will need to fund in the near term so you should take the money off the table out of your employee equity to make sure you have the cash.
Sell enough employee equity to fund these needs and to cover any taxes related to the sale.
Step 2. Decide if you want to keep a certain percentage of your employee equity for the long haul since you may truly believe in the future of the company and want to hold a long-term stake.
I typically recommend keeping 5-10 percent of your company stock holdings at most. Then you can set aside this employee equity and not touch it.
Step 3. Take your remaining employee equity. Here are a few ways to reduce your concentration:
a) Sell immediately: This is simple since you just sell everything as soon as you can.
There is data showing that this way has the highest probability of minimizing your regret relative to the ideal selling strategy. If you want to keep your life simple and this data makes sense to you, then this is the way to go.
b) Sell over time on a schedule:
For example, you could sell 10% of your total vested equity every quarter over ten quarters as soon as your employee trading window opens. The benefits of this option are that if the stock keeps going up, you’ll get some of the upside and you won’t happen to pick the single wrong day to sell since you’re selling on more than one day. Also, you have more control over your tax bill since you can spread it out over multiple years.
Setting a schedule also minimizes emotions since you sell your company stock on autopilot and don’t need to stress about if the stock is high enough at a particular moment.
c) Sell over time on a schedule – more when the price is higher and less when lower.
For example, you could sell based on the sample plan below. Your plan will vary depending on your stock price and risk tolerance.
- 50% of your total vested equity if the stock price is >$100
- 25% of your total vested equity if the stock price is >$50 and <=$100
- 10% of your total vested equity if the stock price is <=$50
The benefits of this option are that if the stock goes up, you’ll sell more and if the stock goes down, you’ll sell less. This way also minimizes emotions since you sell your company stock on autopilot based on the price.
Did you answer these questions?
If you’re an employee at a pre-IPO tech company that is about to IPO, these are the key questions that you need to ask yourself.
- When can you sell your employee equity?
- What type of employee equity do you have?
- Do you have too much employee equity?
- When should you sell your employee equity?
If you take the time to answer these questions with care and planning, you’ll be ready to make the most of your employee equity when your company IPOs.
You can answer these questions on your own if you enjoy this type of work, or you can find an expert who specializes in helping tech professionals make the most of their employee equity.
If you have specific questions about your situation or want to chat with an expert so that you can make the most of your employee equity when your company IPOs, please schedule a free virtual consultation with me.
After 20 years working for companies including eBay, Yahoo!, Intuit, and startups, I made a career change into the financial world as a fee-only financial planner 9 years ago. I earned my CFP®, spent a few years at a boutique fee-only firm in San Jose, worked 2 1/2 years at a leading wealth management firm in San Francisco, and then left to build the firm I wish had existed when I was working as a tech professional.
My mission is to help other Silicon Valley professionals make the most of their employee equity to help them reach their financial goals.