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John is the Outsourced Chief Investment Officer (OCIO) at Secfi. An expert in portfolio construction and investments, he helps individuals maximize returns and control risks unique to their situation.
An IPO can generate life-changing wealth, so it’s pretty important not to fumble it! For those who may find themselves with equity in a soon-to-be public company, there are things you need to do and prepare for to take full advantage.
Many people may think that the outcome of their equity ownership is out of their hands. This is only partially true, as there are many decisions you can make that will impact the outcome. It’s important to know what those are and how to approach them. And your decisions don’t stop when the company IPOs.
If you find yourself asking these questions already or want help answering them, feel free to put some time on my team’s calendar.
A lot of people at startups put off making decisions about their equity for understandable reasons — it’s confusing, it’s not imminent, it’s stressful. Many think, “I’ll wait for the IPO before making any decisions”, but not making any decision is a decision and may pigeonhole you! It’s better to be proactive than reactive. You don’t want to be forced to make decisions that are either not informed or less-than-ideal.
An obvious example is if you leave your company, or are let go. You’ll have to make a decision about what to do with your equity. And the company may be a great one — despite your personal feelings about leaving. Not being backed into a corner is a major reason to get ahead of your equity, but really it’s about creating flexibility to get the most out of it if, and when, an exit event happens.
So here’s what to start thinking about now:
Generally, exercising earlier rather than later can save you tens of percentage points in taxes. But it also carries risks too — a later-stage company is more likely to exit than an earlier one, for obvious reasons. You have to weigh the risks and benefits and make a decision that is best for your family.
Should I self-fund it or finance it? If I’m coming up with the cash myself, where should I pull it from? What part of my portfolio should I sell to generate the funds for the exercise? Does it make sense to tap retirement assets to exercise?
Taxes, portfolio diversification, and investment strategy will play a role in the optimal decision.
Maybe your company offers a tender, maybe there’s a secondary market for your shares, or maybe you’re able to get financing that offers you liquidity. Should you take it?
Well, it certainly depends. Your cash flow situation and balance sheet will matter as will the “moneyness” of your options and the company’s plans/likelihood of an exit.
It’s often a good idea to diversify when given the opportunity, but you’ll also want to look at how much you should sell and from which grants in order to manage taxes and set yourself up for potential future gains.
It’s easy to think the IPO is the end of the road. Yes, it is a major milestone but it’s hardly the end. When the company goes public, employee shareholders are at the beginning of another set of consequential decisions.
Yes, when to sell is a major one. But there’s quite a bit more to it than timing the sale. It’s ultimately about what the windfall means for your life. How will you use this event to achieve your financial goals? Whether that’s buying a house, planning for retirement, or taking an extended sabbatical to figure out your next career move. At the end of the day, the IPO is the moment when things get real. It can be easy to view it as a lottery ticket: you get some cash or you don’t. But it’s not a binary outcome, the decisions you make today can materially impact the windfall that builds a financial foundation for the rest of your life.
Here are decisions you’ll likely need to make once your company does go public:
Typically, there’s a lock up period for employee shareholders — often six months after the date of being listed, but it can vary company to company. However, there is the chance that you may be given the option to sell some earlier. Sometimes, this is based on criteria, like if the stock price increases by a certain percentage, employees can sell some percentage of their holdings by some date.
So, should you? Well, you’ll need to ask yourself (and your financial advisor) some questions, especially: What’s your outlook on the company? Most IPOs experience a first-day “pop.” Historically, that pop has averaged 19%1, but the range of potential outcomes is wide.
And also: Is the potential extra return worth the risk for you? If this event is catapulting you to a different level of financial security the decision may be different than if this event is adding to your already robust financial situation.
It’s likely that you can exercise during the lockout, but you should check the paperwork you’ve been sent from your company. Or, you can ask your company’s equity team.
Again, exercising options earlier can help you reach the holding period that makes your gains eligible for long-term capital gains status, potentially saving you a lot of money. All else equal, you want that clock to start ticking as early as possible to give you the most flexibility.
The media and financial analysts will be watching the lockup expiry like hawks. The potential supply from insider selling might mean investors will be cautious until the share overhang from the lockup is over. In other words, there is often a large number of sales when the lock up ends because employees can finally sell! This can lead to a dip in price, though often temporary.
The right decision will depend on many factors similar to those in the previous point. Often, diversifying as soon as you can makes sense, especially if the stock makes up a significant percentage of your net worth. The goal is to move some of that into more reliable investments.
How much you should diversify / sell and when depends on your own financial situation, as well as your outlook of the company in the short- and long-term.
When a stock trades publicly on an exchange, there is much, much more liquidity available than when it’s private. This is great because it means transaction costs are lower, valuation certainty is higher, and you can sell almost anytime you want (except when markets are closed).
“Liquidity” is multidimensional. A narrow spread between the “bid” and “ask” (the price you can sell/buy at) may be great for trading costs but may only apply to a limited number of shares. If you have a lot of shares to sell, you also care about the “depth” of the order book.
One way to avoid getting poor prices is to spread out your trading over time and use limit orders. Think of it this way: If a grocery store has millions of boxes of Cap’n Crunch to sell, the natural buyers may run out of demand and the store will be forced to lower prices on Cap’n to get others interested in buying. You don’t want to be selling all the Cap’n Crunch all at once, it’s better to space it out so supply and demand are more balanced.
This is a way to designate a stock sale plan ahead of time so that you don’t run afoul of insider trading rules. The trading is outsourced to a third party and executed according to the predetermined plan. It’s most common for officers and directors of a company that have access to inside information.
Tax rates are different depending on the holding period, type of stock, and where you live. It can get complicated. Especially if you paid the Alternative Minimum Tax (AMT) upon exercising and want to use your carry forward credit upon sale of the stock. This is why working with a financial and/or tax professional is imperative when making these decisions.
Do you like being surprised by bills? I don’t. With a windfall like an IPO, your tax bracket is likely going to be higher than a typical year. Are you setting aside enough to cover your tax liability? Withholding too little relative to your eventual obligation can subject you to additional risk. Withholding too much means you missed out on using those funds.
Ooooh, think of all the possibilities! A house? A vacation home? A trip of a lifetime? The possibilities are literally endless.
One of my favorite investing quotes is: “Don’t risk what you have and need for what you don’t have and don’t need.” If this event is establishing a baseline of financial security/freedom for you, it’s probably best not to YOLO into a concentrated portfolio and instead invest the proceeds in a more reliable and diversified way. The larger your portfolio relative to your needs, the more idiosyncratic moonshots you can take.
But until you’re set with the basics, you should diversify! What does a diversified portfolio look like? I could spend pages and pages describing the considerations for creating an asset allocation and a portfolio. For now, I’ll give you a good starting point.
The “market” is the default portfolio. What is the market? Well, it’s every investable asset possible in its proportional weight. That portfolio is impossible to own, so you have to take some practical shortcuts. For your stock portfolio, it’s all the listed stocks on all the exchanges all over the world in their proportional weights. There may be reasons to deviate from this portfolio. But if you are deviating, ask yourself why. Do you really have a good reason? The S&P 500 is roughly five hundred stocks. There are over 10,000 publicly traded companies worldwide. If all you own is the S&P 500, you’re not all that diversified in my opinion.
These are just some of the many, many questions you’re likely to ask yourself, those around you, and hopefully a competent advisor. There will be others, like, “should I set up trusts for my children? And how should they be structured?”. If you’re charitably inclined, you may want to explore tax efficient giving strategies. You’ll also likely look for other ways to minimize your taxes among a myriad of other decisions.
One thing to remember is that these questions don’t necessarily happen once, and they don’t happen in a vacuum. A financial and investment plan is a living, breathing thing. It changes when it needs to, and when you want it to.
Changing jobs, having children, buying a home, moving to a new city, angel investing, etc. may all be reasons to make new or different decisions with your money.
1Source: https://site.warrington.ufl.edu/ritter/files/IPO-Statistics.pdf