Pre-IPO Stock Options: What to Consider

September 16th, 2020

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Stock options are the dream of every worker at a startup, and perhaps the reason they choose the job.

Moreover, stock options are a significant part of the compensation package. A pre-initial public offering (IPO) is the announcement for which they have been waiting. Within just a few years, they are rich beyond their wildest fantasies.

At least, that’s the myth. It does happen to some employees, especially those in tech, but those great riches are still more the exception than the rule. Still, exercising stock options can provide many employees with significant income.

Pre-IPO Stock Options

Young companies can’t offer employees the salaries and perks of more established businesses, but they can lure employees willing to work hard by dangling the possibility of pre-IPO stock options. These employees will own a piece of the company, and the opportunity to become millionaires.

Of course, there’s also the potential to not make money. If the IPO doesn’t take place, your options aren’t worth much, if anything, because there is no market.

The IPO Life Cycle

The IPO changes a company’s status from private to public. The process can take several years for the company to complete.

First, the company chooses an investment bank with which to partner. This underwriter serves as the broker between the company and investors as shares are initially sold. The underwriter performs their due diligence and files the necessary documents with the SEC.

The second, transactional stage involves efforts to maximize valuation for potential investors. This occurs shortly before going public.

The third, post-IPO phase is when the IPO has taken place and the company is going full speed ahead trying to exceed expectations. Companies that beat estimates over the long-haul are well-rewarded.

Trading Pre-IPO Shares

Keep in mind there are few opportunities to exercise your stock options and trade pre-IPO shares privately. Even under these limited circumstances, no such sale can take place unless the company’s board of directors approves. Your stock option plan document will outline what must take place in your situation.

Because they do not trade openly, determining pre-IPO share price is an art more than a science. The estimated value is probably based on the company’s latest fair value assessment.

If you want to invest in pre-IPO companies, find a stockbroker specializing in pre-IPO companies and raising capital. Another alternative is sprouting wings and becoming an angel investor. Such investors help fund startups when capital is hard to come by.

Only “sophisticated investors,” also known as accredited investors, those high-net worth individuals with substantial capital and experience, can invest in pre-IPO securities. Currently, such people must have a net worth of more than $1 million, not including the primary residence. Those with less than the minimum net worth may still qualify if their individual income exceeded 200,000 for each of the two previous years or their income with a spouse was over $300,000.

Delays Happen

When it comes to pre-IPO stock options, remember that delays in publicly trading a company’s stock happen more often than not. Sometimes, these delays are permanent, and the IPO never occurs.

Delays frequently happen during the transactional stage, when what the company may have expected from analysts or investors fails to occur. Such failures could doom the IPO.

Pre-IPO Valuations

How do you know the value of your pre-IPO shares? Before the company goes public, the calculation of share price is difficult due to lack of liquidity. Look for the company’s 409A valuation, an independent appraisal of how much the stock is worth. The appraiser determines the value based on the particulars of the company, including assets and earnings, as well as the products or services offered.

The strike price, or amount at which employees can purchase equity in the company, is part of the 409A valuation. That price is set at or above fair market value. Keep in mind your options only have value when they are beyond the strike price.

When trying to calculate value of your pre-IPO options, don’t go with the number of shares you have per se, but the percentage of ownership those shares give you in the company.

How do you know the percentage of the company you own via pre-IPO stock options? First, find out the number of shares outstanding and its market cap. Calculate company value by the number of outstanding shares multiplied by the price per share.

If your startup is doing well, its value can grow rapidly. For example, the initial employees might join a firm valued at $1 million. A few years later, that valuation may have increased by a hundredfold or more.

The Lockup Period

The lockup period usually ranges between three to six months post-IPO. During that time, you can’t sell your shares. Allowing employees to sell their shares immediately could cause the stock price to fall if employees and any early investors sell off huge numbers of shares. There are no SEC regulations mandating such lockups, but a company that fails to implement a lockup risks severely harming their stock price. Underwriters of the IPO usually require lockups.

Expect a fall in the share price, usually less than 3 percent, when the lockup period ends.

Tax Considerations

Generally, there is no tax triggered when the stock options you receive your options or sell them. When you sell your stock, you must pay capital gains tax on the sale. However, if you sold pre-IPO shares, you could end up getting hit with the Alternative Minimum Tax.

As of 2018, the Tax Cuts and Jobs Act allows employees exercising stock options additional time to pay the federal taxes owed on the income received from the options. It does not affect payment of state taxes owed, or Medicare and Social Security taxes under FICA. Under the TCJA, employees may defer the income, and thus the taxes, for as long as five years. However, it is not the employee making the decision as to eligibility, but the company.

Under Section 83.1 of the Tax Code, the company must decide on the structure and whether to permit these tax-saving grants. Only companies giving the grant to at least 80 percent of eligible employees will qualify.

Consult a Professional

When it comes to pre-IPO stock options, it is wise to obtain professional advice. Consult with your CPA or other financial professional before making decisions. You want to ensure that you don’t trigger a tax nightmare, and you also don’t want to end up with all your financial eggs in one basket. By exercising your options and holding the shares, you could find yourself too heavily invested in the company’s stock. Should the company run into trouble, you could lose much of your wealth.

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