Let’s talk about stock options that private companies offer and go through the pros and cons of each. You join a great company with an even better culture. They offer stock options component and might be wondering, “…what exactly are these Stock Options and Restricted Stock?” or “…what should I do with my pre-IPO RSUs?”
Common Types of Equity Compensation for Private Companies
In younger private (or “pre-IPO”) companies it is common to be offered stock options, Restricted Stock, Restricted Stock Units, or several other types of equity compensation. These types of compensation exist to incentivize employees to align themselves with the growth of the organization. They can also potentially reap the rewards of an increased value of the business.
Early on in a company it is common for the company to award stock option grants to their employees. These stock option grants come in two variations: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NQSOs). ISOs and NQSOs are similar in that they allow an employee to purchase the stock at an agreed-upon price (called the “exercise price” or sometimes the “strike price”, which is stated in the grant document) at some point in time before the option expires, usually after ten years.
Exercising the option is taking action to purchase stock according to the option’s grant document.
Options are typically subject to a vesting schedule, which dictates when an employee can exercise the option. ISOs and NQSOs differ in how they are treated from a tax perspective at exercise and upon the disposal (sale) of the stock. Options can be worthless. If the fair market value of the stock is lower than the exercise price or “in the money” if the fair market value of the stock is higher than the exercise price.
As a company grows and gets closer to a potential IPO, they may continue to grant option awards. More typically they start to incorporate the granting of Restricted Stock and/or Restricted Stock Units (RSUs) as well.
Note that Restricted Stock is different from an RSU!
Restricted Stock
Stocks owned with restrictions is called Restricted Stock. You are “restricted” from being an outright owner of the common stock until you are vested. This typically occurs when you’ve been with a company for a certain amount of time and/or performance metrics are met.
RSUs
RSUs are also subject to a vesting schedule. There is a difference between an option vesting and an RSU vesting. With an RSU the stock is delivered to you whether you like it or not. When an option vests you have the decision of whether you want to buy the stock or not.
*RSUs are taxed as compensation income upon vesting (with one exception of deferring the taxation using an 83(i) election, if eligible to do so. After vesting, the stock acquired from an RSU is treated as capital gains (long or short-term) upon disposal. Although the focus of this blog post is around private, “pre-IPO” companies, it is worth a quick mention that after an IPO, a company typically emphasizes RSU grants over option grants, and there will usually be a more regular cadence (e.g. annual grants).
Illiquidity issues
But let’s not get too far ahead of ourselves. I’m also here to provide some insight into how unlikely it is that an IPO occurs.
- According to Aileen Lee of Cowboy Ventures, only 0.14% of tech startups reach “unicorn” status (billion dollar market valuation), and of those, only 39% IPO or get acquired.
- That is about 1 out of every 2,000 startups. That said, one of the biggest challenges with pre-IPO stock is the illiquidity of the stock. There isn’t much, if any, of a market for you to sell the stock.
- Even if your pre-IPO ISO is in the money, you could potentially pay a bunch of money to exercise the option and acquire the stock, but have no one to sell it to and actually reap the reward.
Example: If you have 10,000 ISOs with the ability to buy your company stock at $5/share. The fair market value of the stock, based on its 409(a) valuation, is worth $20/share. Sounds like you’ve got a nice profit in your pocket, right?!
You decide to exercise all of the ISOs, write a check to the company for $50,000, and the company delivers 10,000 shares to you. You now own 10,000 shares of the company worth $200,000 but only paid $50,000 for them. This is a nice paper profit of $150,000. If you are unable to sell the shares you have paid $50,000 out of pocket and never got anything in return.
A private company will have many rules and restrictions on reselling the stock. It will be outlined in the grant document and the equity incentive plan document. Securities law also will limit your ability to resell your private stock since the stock is not registered with the SEC.
Back to the example a few sentences above: To actually realize the $150,000 profit while the company is still private, you would have to find a buyer where you are able to legally transfer the stock under a securities law exemption. The potential buyers could include the company, other employees, or other private investors.
There are other issues that stem from pre-IPO illiquidity, such as funding exercise costs and paying taxes. Most people do not have tens or hundreds of thousands of dollars in liquid cash which might be necessary to exercise an option.
Based on how various forms of equity compensation are taxed, you might find yourself in a position where you owe a large tax liability out of pocket.
Exercising pre-IPO options
When exercising your employee stock options (ISOs or NQSOs), you are expected to come up with cash. If you have the cash set aside, good for you! If you do not, there are other ways to finance the cost of exercise.
- Generally speaking I discourage people from cashing out retirement savings. I also discourage cashing out long-term investments to self-finance the exercise of a stock option.
- I do not recommend using home equity (via HELOC) to finance the exercise of an option. In many cases the lender you are working with will not allow you to use the HELOC for other investments. If you receive capital from a traditional source like a bank and the price of the stock goes to zero, you are still on the hook for paying back the loan!
There are also outside financing companies that specifically address the issue of funding the exercise of private company options. In many cases this financing is provided in a nonrecourse fashion. The option holder, is not responsible for the repayment of the loan in the case of the company failing.
You are essentially transferring this risk to the financing company. But have to give up something for this non-recourse benefit: You pay high fees and limit your upside participating in the event of an IPO.
However, even with high fees, a paper by the Stanford Graduate School of Business shows an example (Exhibit 3) where the access to this capital allowing the early exercise of the option can have significant tax savings.
Taxes and RSUs
One common example of a pre-IPO illiquidity tax trap is with a private company RSU. Reminder: RSU is taxed as compensation income at vesting. Further note that the 83(b) election is not available for RSUs.
Let’s say that $100,000 of your RSUs vest. At that point in time, all $100,000 is subject to compensation income. With a publicly-traded company, no big deal! The RSUs can be withheld and/or sold to cover some or all of the tax liability.
Not the case with a private company. The IRS will tax you regardless of if your company is private or public.
However, there are a few ways to address this:
1) your employer helps you finance the cost
2) the RSU has “double trigger” vesting
3) the 83(i) election
Your employer loans you the cash:
If your employer has the cash, they may loan you money (potentially with a favorable interest rate) to help you pay the taxes on your RSU vesting.
You should coordinate with your accountant and your financial advisor when it comes to making the decision on if you should take a loan to help cover your tax liability. Your employer could also pay you a cash bonus (also subject to taxation) to help you with your tax liability.
The RSU has “double trigger” vesting:
The double trigger RSU adds a second vesting provision in addition to the time/service requirement: a liquidity requirement. In other words, the RSU isn’t fully vested until both the time requirement is met AND a liquidity event occurs.
Companies that have incorporated double-trigger vesting with their RSUs include Facebook, Uber, and Airbnb. Double-trigger vesting helps solve the initial dilemma of raising the cash to help cover a tax liability while the company is private, but there are other issues that can arise.
This depends on the exact vesting provisions of the RSUs, lock up periods, the direction the stock moves, and how many RSUs you own.
These aforementioned variables can lead to you paying more in taxes at the highest marginal tax bracket, subject you to market risk once the stock is public, and/or potentially still have liquidity issues during a post-IPO lockup period.
The 83(i) election:
The 83(i) election is a relatively new part of the tax code that was created as part of the 2017 Tax Cuts and Jobs Act. It was put in place to help defer income taxes for five years upon vesting of a private company RSU (or NQSO exercise).
This strategy could end up simply kicking the cash liquidity issue down the road and making it a problem for future you. The 83(i) election is still relatively uncommon, since it is up to each individual company to qualify and actually offer the 83(i) election.
Stock options for private companies and pre-IPO RSUs can get complicated. These various forms of equity compensation are that they can incentivize employees by participating in the growth of the company. They have the potential to significantly increase employees’ net worth, and illiquidity challenges. There are many decisions to be made along the process:
When should I exercise my options?
How will I come up with the cash to exercise my options?
Should I make an 83(b) or 83(i) election?
How do I plan for taxes of my option exercise or Restricted Stock vesting.
All of these questions require careful planning and coordination between the professional advisors in your life such as your financial advisor and accountant. Complexity often brings planning opportunities. We would love the opportunity to get to know you, your situation, and ultimately determine if there is a good fit for working together. Feel free to check us out and book an appointment to start the conversation.
You should always consult a financial, tax, or legal professional familiar about your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns. Past performance does not guarantee future performance. Future returns may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions, and security positions, when sold, may be worth less or more than their original cost.