Working at a pre-IPO company — especially if the company is going public in the near future — can be exciting. Being part of a team that enabled the organization to have such success can be rewarding professionally, without even considering the potential financial rewards.
Managing equity compensation benefits when you work for a private firm is quite different from those you can expect to receive from a public company. In this post, I’ll explain the important rules and opportunities you should understand if you are in this situation.
Benefits and Challenges
One of the major benefits of working for a private company is the opportunity to receive private company stock, which may have a positive impact on your overall long-term wealth. One of the biggest risks, however, is the lack of liquidity and the difficulty of selling private stock.
This challenge becomes especially important when you owe taxes on a vested position, or when you exercise options and you can’t sell your private stock to cover the tax liability. The Tax Cuts and Jobs Act created an opportunity that allows for tax deferral in the case of RSUs and non-qualified stock options, called the 83(i) election. We covered this topic in a previous post, which you can check out here.
The two types of equity compensation grants you can receive when working for a private company are stock options and restricted stock units (RSUs).
Stock Options
Private companies grant two types of stock options: non-qualified stock options (NQSOs) and incentive stock options (ISOs). The taxation rules for each differ.
NQSOs are taxed at ordinary income tax rates at the time of exercise based on the spread between the fair market value and exercise price. When you exercise ISOs, they receive preferable tax treatment, as long as certain holding periods are met. You have to hold ISO shares for one year from exercise and two years from the grant date in order to qualify for the preferable tax treatment. In this case, the “spread” may trigger AMT tax liability at the time of exercise, but you qualify for long-term capital gains tax treatment for the gain over the exercise/grant price.
Early-Exercise Options: This is a popular strategy that means exactly what its name suggests. It has its risks, depending on the future of the company’s stock valuation. You exercise your stock options early and file a Section 83(b) election within 30 days of exercise. The company has a repurchase right that typically decreases as the regular vesting schedule progresses. This strategy is most often used when you do an early-exercise at the time of the grant. Remember that if you exercise ISOs right away, the fair market value equals the grant price and, therefore, there is no spread for tax purposes.
The major drawback to this strategy is that you have to come up with the money to exercise, but you can’t sell any shares to pay for it. This can be a very lucrative strategy if the stock price soars after the IPO. You pay taxes on a lower spread, if any, as well as the cost to exercise, which will be based on a much lower share price. However, there are huge risks, as the company stock can be lower after an IPO. In this case, you’ll have a situation where your cost of exercising and your tax burden at the time of exercise might be much higher than your benefit from when the company goes public. Only utilize this strategy with the help of a financial and tax professional and if you are ready to risk your proceeds.
Restricted Stock Units (RSUs)
The case with RSUs is much simpler: you are vested based on the company’s performance or most often on a pre-set time frame. At vesting, RSUs are subject to ordinary income tax, as mentioned above. Even though you might be vested in the company stock, that doesn’t change their illiquid nature and doesn’t change the fact that you have to pay taxes. However, you may be able to take an 83(i) election if your company qualifies for the rule.
The most common strategy for avoiding these taxes is what’s called double-trigger vesting. Under this scenario, a pre-IPO company will set a second condition for vesting, which most of the time requires a liquidity event for vesting. This avoids the need for you to pay taxes on an illiquid stock. However, in many cases, this strategy comes with a huge tax liability right after the company goes public. You will be able to sell shares to pay for the tax liability, but your marginal tax rate can also increase significantly, so be prepared for that.
Is your company preparing for an IPO? Do you have questions about your equity compensation? I can help provide some clarity. Get in touch with me today.