After having to answer your grandparents’ question of “Where exactly do you work again?” at many family dinners and going through countless conversations with your friends about working at a startup, the company you work for has finally done it. They are in Initial Public Offering (IPO) registration. Once you finish sifting through the congratulations messages and celebrating with your coworkers, it dawns on you. What exactly does this IPO mean for me, and is there anything I need to be doing financially to prepare for it?
The IPO market has been lackluster for the past couple of years due to higher interest rates and a difficult public landscape. However, as sentiment has begun to shift, and more and more companies are either filing or predicted to IPO in 2024, many employees might find themselves asking these “What now?” questions.
An increasingly common scenario
While your company getting ready to go public is an exciting thing, there are a few important steps you should be taking to make sure that you aren’t leaving any money on the table.
The first and most important of these steps is to educate yourself about your current option package and what type of stock options you have. Some common misconceptions are that stock options mean you automatically own company stock, the company will exercise your stock options for you, or upon a liquidity event, your stock options will automatically convert to shares. This is typically not the case. For employees to own stock in their company, they will most likely need to pay to exercise their options.
Once you’ve educated yourself on what your stock options mean, you must determine if exercising these options makes sense for you and your financial goals. There are some cases where it may be more financially prudent to let your options expire rather than putting up the funds to exercise.
One such case would be if your option strike prices are far above the price at which the company is expected to IPO. This would effectively mean that you would be paying a premium for the company stock when you could simply wait for the IPO and buy shares at a lower price. While this used to be a very rare scenario, with company valuations having dropped significantly from their 2020 and 2021 heights, many employees may find themselves in this situation. The most recent example of this is Instacart, whose IPO ultimately valued the company at around $10 billion, compared to a previous funding round of $39 billion it received in 2021.
As an employee, if your strike prices for your options were based off of a $39 billion valuation, you would have been better off letting these expire since they were “underwater” when the company announced its IPO.
A potentially large expenditure
After all of this due diligence is out of the way and you’ve determined that it would be financially lucrative to exercise your stock options before your company IPOs, you’ll have one more large consideration before moving forward: How will you pay for it?
Let’s assume that you have 1,000 stock options of a hot company that is expecting to IPO in 2024 with a strike price of $10 that you were granted years ago. The company has done well, and the price of common indicated by the 409a is now $50 a share. To exercise all your shares, you will need to come up with $10,000, as well as likely a few thousand in AMT tax, depending on which state you live in and what your income is. That’s over $10,000 you will need to come up with to have access to the company stock. There are a few solutions with how to prepare for this large capital expenditure:
- Speak with your stock administration professional to determine the total amount you will be responsible for if the company IPOes at a specific price. Once you know that value, be sure to start setting aside money to prepare. Additionally, there are many AMT calculators online that can also assist with getting an estimate of what your tax liability might be. As always, it’s a good idea to speak to your CPA to determine more precise amounts.
- Investigate funding vehicles to exercise your options. Today, there are many solutions for employees who do not have the immediate capital to exercise their options. Options exercise funding can be done through traditional recourse loans with an interest rate, or other solutions that are nonrecourse and interest-free in exchange for a portion of the equity when the company exits.
By weighing paying for the exercise yourself against receiving funding from a third party you’ll be able to make a better decision regarding which plan makes the most sense for you and your financial goals.
Education is key. Treat your options with the same due diligence you apply to salary and benefits. By making informed decisions, you can maximize the potential reward for your hard work and capitalize on your company’s IPO journey.
Scott Chou is the CEO of ESO Fund.
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