Assumptions: CA resident, married filing jointly, $200k base income
If Employee A waited to exercise until the first IPO pricing of $80 a couple weeks ago, the tax bill jumps up to ~$119k.
You probably know what's coming next. If Employee A waited until today to exercise at the $250 public price, then the tax bill goes up to ~$447k.
Stock options typically get more expensive to exercise over time. After an IPO, most will have to resort to doing what's called a cashless exercise, which means you buy and sell your shares in the same transaction.
It's cashless because you don't need cash upfront: you can cover the exercise costs with your sale proceeds. Taxwise though, this is the worst scenario. You'll pay ordinary income rates (=high) on ALL gains.
So why would anyone volunteer to pay cash to exercise ISOs prior to IPO?
If you exercise and hold on to your equity for two years after grant and one year after exercise, you sell in a so-called 'qualifying disposition' and convert everything north of your strike to long-term capital gains tax rates (=low).
Let's say Employee A decided to exercise in mid-2020 when the 409A was $30. She pays $53k then waits a year before selling after the IPO. If we assume the share price will be $250 when the lock-up period ends in a couple of months, she converts her gain to long-term capital gains and gets an extra ~$135k in her pocket. In other words, she's 20% better off 🥳
By the way, that extra ~$135k is with the $53k exercise costs already factored in. So it's all additional upside.
Don't just wait and see. Each IPO is bittersweet. I'm always happy for the employees, but I also talk to many who realize how much they left on the table. After each IPO, I always hear the same thing:
"I wish I'd exercised years ago."
Stock options and taxes are complicated, and startup valuations are uncertain. Most startup employees do not feel well equipped to make these decisions. Investment risk, available cash, personal situations, ability to leave job, etc. all play a factor. Planning ahead allows you to anticipate these risks and avoid (some of) the costs.
So startup employees: Make sure you're being conscious about your stock options. Know the potential risks and benefits from exercising. If you don't know, talk to an equity strategist or people that do know. There's too much money on the table to ignore.
Feel free to hit me up for a quick chat in the bottom-right if you've got any questions.