When a company is being purchased or going through an initial public offering, executives and employees receiving equity compensation should understand how their shares will be handled before, during, and after the transaction. It is not always what you think, and mistakes can be costly.
What do you have pre- and post-sale or IPO?
- What are your options or other forms of equity award shares as a percentage of the company’s total outstanding shares? Are your shares being diluted due to additional rounds of funding?
- What are the terms for unvested options if the company is sold? Are they canceled, accelerated, or forfeited if your employment is terminated on the sale?
- What kind of options are you granted? Non-qualified stock options (NQSO) or incentive stock options (ISO)?
- If venture capital is involved, is there a separate class of “convertible preferred stock”? What are the preferred terms of that stock?
- For an IPO, will they have to do a “reverse” stock split? And if so, how many shares will you have at the target price?
- Do you have a “lockup” period, and how long (180 days is standard)?
Now that you have all the above questions answered, what should you do?
Should I Exercise Pre-Sale or IPO?
If you exercise non-statutory options (NSO) before the sale or the IPO, you will owe earned income tax on the spread without being able to sell the stock to pay the tax. Do you have enough money to pay the taxes? What if the stock is less after the lockup period and your taxes exceed your gain?
For incentive stock, options can be advantageous from a tax perspective but can trigger ordinary income tax, alternative minimum tax, or no tax. Taxes are not due at exercise for ISOs, but exercising can trigger the alternative minimum tax or ordinary income tax if shares are sold before a year and a day from the exercise window. Exercise timing is especially important with ISO options. Did you exercise them in a time that would allow you to hold them for more than a year before the tax is due? Would the potential lockup period prevent you from selling shares to pay the tax due on April 15th, the year following the exercise? Like the NSO options, you have the risk of the stock value going below the taxes due during the lockup period.
If the stock option plan allows for it, you may exercise shares before they vest to start the clock for the capital gains holding period. Look at taking an 83(b) election within 30 days of the exercise and transfer of shares. Since the shares are illiquid and have little value upon a start-up, you want to make this election before the company starts additional funding rounds.
In addition to the above, it’s important to understand if the stock option plan has repurchase rights in the plan agreement, which requires the employer to repurchase the shares through the repurchase rights provisions in your grant. This agreement can be used for unvested or vested shares. You may forfeit the shares without repurchase rights when separating from the company before vesting. You will also need to understand how the repurchase right determines the share price.
A company sale can create great wealth, but without proper planning, one can find themselves in difficult tax situations and much less wealth than they were counting on. We believe it could be helpful to start working now with someone who understands the tax and equity compensation issues with a company sale or IPO to avoid the mistakes and maximize what you can keep.
Interested in learning more? Contact SignatureExecutive at dan.dubay@signaturefd.com.
