Stock option for pre-IPO companies – A complete guide
This article goes into all the necessary details about stock options for pre-IPO companies.
As a firm organizes an initial public offering (IPO) of its common stock, there are several key compensation-related concerns to address. When you exercise your reward stock options, it can be a challenging decision with severe consequences for financial management and taxation if you don’t have a proper understanding of stock options for pre-IPO companies. The pre-IPO stage raises a whole new set of problems that you should be aware of. This article goes into all the necessary details about stock options for pre-IPO companies. We will discuss all the things to consider for stock options for pre-IPO companies and stock options finance in pre-IPO companies for founders to remain informed while issuing stock options in employee compensation.
Stock option and pre-IPO companies
In recent years, start-up firms often remain private for a lengthier time before becoming public compared to the early 2000s. When a typical firm goes public, it is now closer to 12 years old. Companies are obtaining more cash from private sources, meaning that a higher amount of equity growth will go to pre-IPO investors and workers rather than public investors. The concerns surrounding pre-IPO incentive stock options (ISOs) are especially significant due to this. As the period between inception and IPO becomes longer, an increasing number of workers face the dilemma regarding the costs and advantages of a pre-IPO ISO exercise.
Understand pre-IPO companies
A pre-IPO or pre-initial public offering is a late-stage fundraising effort by a private firm before its registration on a public market. Pre-IPO companies’ main part of their compensation programs is giving out equity awards and stock options. Over three-quarters of private organizations use stock options in the compensation package. Stock options are not just granted to the most senior executives. Half of the organizations give stock options to more than 80% of their employees, and a third give them to all employees.
What does a stock option in pre-IPO companies mean?
ISOs are not subjected to taxation to the employee when granted, and they are not taxable when exercised unless the ISOs’ worth causes the employed person to pay alternative minimum tax (AMT). When the stocks are finally sold, the difference between how much money was made and how much it cost to exercise the option is considered a capital gain or loss. ISOs are quite valuable when they are given to a private business when it is still young, and its valuation is low.
At the time of grant, NSOs are not subjected to tax for the employee. The gap between the principal amount and the fair market value of the NSO is recognized as wage earnings at the time of exercise, and both normal income tax rates and payroll taxes are required on the net earnings. The price of the remaining shares at the time of exercise will become the new cost basis. Any subsequent gain (or decline) in comparison to this value is considered a capital gain (or loss) at the time of selling.
- For employees – An individual who owns ISOs will receive reduced AMT taxes on a lesser cash amount and reduced capital gains tax rates on any later rise in value. Similarly, a worker who owns NSOs will owe regular income taxes on the net proceeds without deducting the reduced capital-gains rate. Early exercise stands to reason, especially before a fundraising round or an IPO when valuations are likely to rise. In this case, the employee would file taxes based on the prior round’s stock price and will benefit from an almost instantaneous increase in value.
- For a company – Stock options by pre-IPO companies are used for recruitment, retention, and incentives. The stock option attracts highly qualified and risk-tolerant personnel who are ready to forego present remuneration for the chance of considerably higher future pay if the firm succeeds. Early-stage enterprises can cut cash outlays by providing some salary in shares. Stock option encourages workers to stay with the firm until awards are completely vested and full value is realized at a liquidity event. In recent years, start-ups have waited longer to go public, complicating this arrangement. Companies are obtaining more private money, so pre-IPO shareholders and workers are getting a higher share of equity growth.
How do stock options for pre-IPO companies work?
In a public market economy, the value of your incentive stock options can be estimated by comparing their exercise price to the current trading price of your company’s shares. You can use this value as a starting point for decision-making, even if you don’t intend to execute or sell the option anytime soon.
However, in contrast, the pre-IPO shares are not traded publicly and may not have a clear value. Any shares you buy before an initial public offering (IPO) will likely be priced at the most current estimate of your company’s fair value. If you want to know if the stock price went up or down after you exercised, you’ll have to wait until the next valuation comes around.
You will become a shareholder in your company once you decide to exercise your stock options. While these shares do share certain similarities with publicly listed company shares, there are also key distinctions. The value of the stock in a Pre-IPO Company is valued by employing third-party software or professionals who are well-versed in examining the market so as not to leave room for error.
Compensation issues and strategies pre-IPO companies should consider
Here, we will mostly talk about issues related to a stock option since this is likely to be the part of the company’s compensation program that will change the most.
- Valuation issues – Whatever stock option is given with an exercise price below the time of issue, “fair market value” would be taxed “early” whenever it vests instead of when it is exercised. It would be taxed again at the close of every calendar year and then until it is canceled, lapsed, or exercised. In this case, a 20% federal tax and perhaps late payment penalties and interest will apply to all relevant employment and income taxes. SEC personnel will normally assess the firm’s stock valuation relating to stock option awards made during the 12 months before the IPO, thus, the company must verify the valuation is supported throughout this time and moving further into time. During this time, many pre-IPO firms get third-party asset valuations. Firms attempt these valuations more often than early phase private corporation valuations and coordinate the awarding of company stock with the valuations to avoid a meaningful lag time between both the valuation and the stock option award date.
- Share reserve – A Pre-IPO firm should assess the amount of its stock plan share reserve before the IPO and authorize any increase before the IPO since it is simpler to get stockholder approval before the IPO than after. Pre-IPO firms should reserve enough stock-plan shares to make awards for approximately two to five years following IPO. The stock-plan overhang for a business going public generally varies from 10 to 15%, but for IT companies, it’s 15 to 20%.
- Equity grants – A company’s pre-IPO equity plan is normally reiterated in its entirety at IPO. This has several causes:
- Pre-IPO stock plans sometimes contain requirements that apply solely to private corporations, such as stock transfer restrictions, first refusal options, lock-ups, and securities laws.
- Post-IPO proposals typically allow for all kinds of equity grants, such as stock options, restricted stock, restricted stock units, stock bonuses, and stock appreciation rights, and should include aggregate and individual award limits, as well as performance targets and regulations relating to performance awards that conform with IRS regulations.
- IRS limits the deductions firms can claim for certain executive officers with specific exceptions.
- Finally, the company will need to evaluate the post-IPO stock plan share reserve mentioned above.
- Type of grants – Pre-IPO corporations award stock options since they’re most valuable when the stock price rises. A few technological businesses have given pre-IPO restricted stock units owing to talent competitiveness and recruitment pressure. Pre-IPO restricted stock units are complicated and require legal expertise. Most firms will eventually blend options with restricted stock units. Restricted stock units give more retention value when the firm’s stock price thins and, in some circumstances, some value as the stock price falls. Performance awards are less popular in pre-IPO firms due to the difficulty of creating adequate performance targets. Post-IPO corporations will eventually combine non-performance and performance-based stock incentives. Stockholders, institutional investors, and proxy advice firms appreciate properly structured performance rewards because they match executives and other workers with the company’s goal.
- Timing of grants – Pre-IPO corporations have routinely given stock awards upon hiring and on other occasions. Since tech businesses are taking time to go public, established pre-IPO companies typically switch to new-hire rewards and yearly equity awards, like post-IPO companies. Pre-IPO and post-IPO firms should evaluate the timing of stock issuance as part of their payment strategy.
- Compensation Philosophy – Pre-IPO enterprises should plan a post-IPO compensation strategy. A compensation philosophy includes forms of remuneration and a pay mix, taking into account the firm’s near- and long-term objectives for its remuneration policy and the market in which it competes for talent. It helps firms select a comparable group of companies with which they contend for talent or who represent suitable standards for the industry’s pay program and examine the reference group’s reward policy to comprehend how the firm’s compensation program compares to similar competitors. Equity awards can help retain and motivate Executives.
Pre-stock options and early exercise
While there are several factors to consider when selecting how to handle your ISOs in general. ISOs from pre-IPO firms have unique implications that should be recognized as part of your overall financial strategy.
Advantages of pre-IPO stock option exercise
Despite the tax implications, exercising pre-IPO options can have significant benefits.
- The potential for significant stock gain in the years after an IPO.
- Practicing ISO early on can assist in lessening the overall AMT impact.
- Another tax advantage of pre-IPO execution is that the time for a qualified disposition starts when the option is exercised.
- Whenever the post-IPO lockup period ends, you can meet the eligible disposition holding condition.
- It can enable you to dispose of your ISO units sooner than if you waited till after the IPO and yet receive potentially favorable long-term capital gains.
Tax implications of pre-IPO stock options
Pre-IPO firms’ taxes are significant because these shares are harder to liquidate. The company may face a tax burden upon exercise without being able to sell part of its purchases to pay the payment.
Whether you hold ISOs or NSOs – will determine your tax consequences. Pre-IPO sales of ISOs might create tax complications since exercising ISOs may trigger an AMT obligation. Exercised pre-IPO ISOs may boost your AMT taxes but not your ordinary tax burden, provided you don’t trade your ISO units throughout the year. If AMT taxes surpass ordinary taxes, you’ll pay extra.
NSOs are taxed differently. NSOs don’t raise AMT liability, but the bargaining part is taxed as regular income. Exercise increases your income in the exercise year, which might boost your taxes.
Why should you prepare for a lockup period?
Lockup periods may hinder stock sales. During this period, generally 6 months post-IPO, you may not be allowed to sell your stock under an investment bank agreement. You need to be prepared since you won’t be able to access the capital of those stocks until after the lockup period has passed if you need cash suddenly.
How to exercise early in pre-IPO companies
When exercising vested equity in a private firm might be tricky. Consider your funds on hand, tax ramifications, and the danger of losing your investment if your firm fails to exit. If your organization provided early exercise and was established less than a year ago, you should think about starting early. Otherwise, waiting until your firm starts the process of going public before exercising is a better option.
- Early exercise if a company is less than 1-year-old – Early exercise might reduce or eliminate taxes since your options’ fair market value could be equal to or slightly over their strike price. Your options could come with a modest strike price, say cents per share, so exercising a large number of shares would cost just a few thousand dollars and not result in substantial tax liability. If your firm succeeds, you’ll save tons of taxes.
- Get advantage of 83(b) election – 83(b) election must be made within 30 days if options are exercised early. This is a unique election due to which the IRS records ownership income even if you haven’t vested your shares. Early exercisers won’t owe taxes.
- If you are not an early employee – If you have sufficient funds on hand and are prepared to take the chance, you can try exercising your stock as it vests and afterward holding onto it until a liquidity event occurs. The advantage is that it lowers your possible tax burden. If this is something you wish to investigate, speak with your accountant.
- If you leave your job before IPO – If your firm remains private and hasn’t declared intentions to go public, you should only exercise what you’re willing to lose. After you leave, the time on your window is limited to exercise the shares you acquired. The great majority of firms offer you three months from the day you leave to exercise.
What is the ideal time to exercise your stock options?
For most people, the best time to exercise is when their firm begins the process of going public. Working backward since when your shares are expected to be liquid and priced at what you consider to be a fair price is required. You should first ensure you are eligible for the substantially reduced long-term capital gains tax rate. Furthermore, you can’t sell your shares for nearly a year after a firm files for an IPO. Waiting until your firm begins the IPO process ensures that your stocks will be valued more than the strike price and also allow you to trade your options as soon as feasible, even while eligible for long-term capital gains taxes.
Manage your pre-IPO stocks and shares with Eqvista!
Working with a professional tax accountant is essential if you want to fully grasp the tax implications of exercising your assets. There are complex tax methods to consider when exercising private or public business shares. Exercising is a decision you won’t make very often, and doing it wrong isn’t worth it.
If you are unsure how to deal with pre-IPO stock options while being legally compliant, Eqvista is right for you. Eqvista was founded by a group of accountants, attorneys, valuation specialists, and entrepreneurs to assist businesses in running effectively. We can handle everything from helping you exercise your stock options to preparing you for the IPO event.