Updated for 2021: Giving purpose to my RSUs and stock options when my company goes public
“Pay me in equity”. It’s a phrase worth adopting, because it is one of the ways that you, as a professional working in technology, communications, finance, healthcare or other booming industries, can materialize your wealth. It’s a phrase that some of the most influential people tout - so much so, that Beyoncé made a t-shirt with this very statement.
We’re republishing this post from 2020 with some updates for 2021!
The initial public offering (IPO) market remains active in 2021. An IPO is a time when the public markets get to participate, or invest, in businesses that once were only available for investment by large institutions and qualified investors. An IPO presents an opportunity for employees who have long held private stock that wasn’t actively traded on a public market. But this opportunity comes with challenges, because decisions will need to be made at a time when you are able to visibly track the stock price at every moment. News outlets will be following, and analysts will be speculating; it might become hard to separate signal and noise. As an employee of a company that has recently gone public, you’ll inherently have your own biases about where the stock price might go. In this week’s blog, we’re going to teach you how to create a plan for your stock compensation. It doesn’t matter if your company has already IPOed or if it’s about to. Having a plan will equip you for both circumstances. The more prepared you are ahead of time, the less difficult your decision making will be when it matters.
According to Kiplinger, “The mega-trend of digital transformation continues to thrust more companies into the public markets… Thanks to pushes from the likes of online brokerage Robinhood, trading stocks has become free (or much cheaper) for most investors. That has helped spur larger numbers of young investors looking for high-growth opportunities, like IPO stocks.” Some of the names this year include:
Authentic Brands Group
Traeger
Couchbase
The Fresh Market
Robinhood
Instacart
Thoughtspot
Rivian
NerdWallet
Discord
Databricks
Nextdoor
Ascensus
As an employee of a company that is going public or has recently gone public, an IPO should be a super impactful experience. It may change the way your company does business, perhaps now putting a greater focus on quarterly earnings. Your company may change your compensation package to better align with industry standards, including how you are paid in company stock. Your company may add additional guardrails on how you can buy and sell company stock. These changes often have ripple effects far beyond your day to day tasks at work. As financial life planners, we have seen the many ways in which these external forces can impact the personal lives of both individuals and their families. As mentioned above, it’s important to be prepared and understand your options ahead of time so you can maximize your IPO instead of letting it disrupt your life negatively. Next, we’re going to dive into the financial decisions you have control over in these cases, and discuss how to create a plan for your stock compensation.
RSUs vs Stock Options
Most often in private companies, we see equity granted in the form of stock options - either incentive stock options (ISOs) or non-qualified stock options (NSOs or NQSOs). In public companies, it’s more common to see equity granted in the form of Restricted Stock Units (RSUs) and Employee Stock Purchase Plans (ESPPs). We won’t touch on ESPPs too much in this blog, but do want to spend some time explaining the different types of stock comp that you earn as income - namely, ISOs, NSOs and RSUs.
Stock Options (ISOs vs NSOs)
Stock options give you the right - but not the obligation - to buy a stock at a certain price (called the exercise or strike price), by a certain date. It’s important to understand that options expire. This expiration date is critical for you to know, because after the expiration date, you’re no longer eligible to buy into your company. Options can come in two forms: 1) Incentive Stock Options and 2) Non-Qualified Stock Options. The tax details of these two instruments are too complex for the current post, but a good heuristic to follow is that ISOs have better, but more complicated tax consequences. The complexities of this scenario are a great reason to work with a CFP® who specializes in stock compensation as well as a qualified CPA®.
RSUs
Restricted stock units are equivalent to owning a share in your company’s stock. When you receive RSUs as part of your compensation, they are taxed as ordinary income. Think of it like a cash bonus that your company immediately invests into company stock and gives to you instead.
If you want to read more about the various types of ways you can earn company stock, here is a recent blog post where we dove deep into the subject.
So, should I invest in my company stock?
Practically speaking, everything you need to know about your stock compensation will be discoverable in the legal documents produced by your company. These documents will outline your vesting schedules and what happens to your company stock in the case of an IPO - specifically, how your stock vesting is impacted by the IPO. In some cases, this accelerates your vesting, but in other cases, it does not. This can materially impact how much stock you have when the company does go public. These documents will explain how your stock options and RSUs are governed, and we recommend reviewing them on your own as well as with the assistance of a CFA® and CPA®.
For planning purposes, we want to break down the structure of your decision making into two key time frames:
Pre-IPO
Post-IPO
Pre-IPO: What should I do with my vested RSUs and vested stock options?
Typically, you will receive stock options or RSUs on a vesting schedule. This vesting schedule can vary from monthly, to quarterly, to annually, and is often based on the following factors: time spent working for a company, your own personal performance with the company, and/or the company’s performance. This will all be outlined in the grant documents and legal documents governing the company’s stock program.
If you’re receiving stock options from a private company, you have the option to exercise those stock options as they vest. This means that you’re giving your company cash in exchange for shares in the company, but frankly - because it’s a private company, you may never be able to sell those shares. This might seem risky, but there is actually good reason to exercise your private company stock. The main reason is tax efficient money making! When you exercise your stock options early, you’re starting the clock on long-term capital gains, which are taxed at more favorable rates than ordinary income.
Let’s say you exercise 100,000 options at $0.10 when the company stock is worth $0.10. You pay your company $10,000 for 100,000 shares. A few years goes by and your company goes public at $30/share. At this point your 100,000 shares are worth $3,000,000. When you sell your stock, you make $29.90 on each share, all of which is taxed as capital gains. If you’re in the top tax bracket, you’ll pay 20% of that gain or $598,000 in Federal Taxes. After taxes (assuming no State Tax), you’re left with $2.4 million.
If you decided instead to wait to exercise your shares when they are worth $20, and a year or so later when the company goes public you sell at $30/share, you will pay $19.90/share of ordinary income tax and $10/share of capital gains. If you’re at the top tax bracket, you’ll pay 37% of the $19.90/share and 20% of the $10/share OR $936,300. After taxes (assuming no State Tax), you’re left with $2 million.
So what are some of the reasons people wait? Here are a few cases that you might experience in our example above:
When the stock was worth $0.10, you were afraid it might go to $0.
When the stock was worth $0.10, you didn’t have the money to buy the shares.
When the stock was worth $0.10, you worried that the stock may never IPO.
These concerns make decisions around stock options more challenging than being granted company stock. You have to make the decision to buy into the company. And there is absolutely a chance that the company doesn’t go public and/or the company goes under and the money you invested goes with it.
In both of these examples, we’re assuming you are exercising all 100,000 vested options. If you’re an Airbnb employee and your stock options are expiring, buying all of them may be your only option to claim your stake in the company. But at companies with a longer time horizon to the IPO, and with options that aren’t close to the expiration date, employees have more choices. One strategy combines both of the two scenarios above: exercise some stock early and wait to exercise the remaining stock until your company is public. As you explore what amount to exercise early, consider what percentage of your net worth you want invested in your company. If you’re struggling with answering that question, two other considerations can help provide clarity: 1) knowing the amount of money would you be willing to lose, and 2) the amount of money can you afford to pay to buy stock every year. There’s no right answer, but deciding your financial boundaries and limits will help you make a more rational choice about how much to invest.
Now let’s turn to RSUs. RSUs are simpler, because you are given company stock. Outside of deciding what percentage of your bonus to allocate to company stock vs. cash (and we’d think about this with a similar approach to how many options you want to exercise), you don’t really have to make a choice on when to buy. Your vesting schedule determines the stock you own. However because there is no public market to sell your company stock, sometimes your RSUs don’t actually vest until the company divests a material stake (sometimes known as a Tender Offer) or has an IPO before you actually receive your shares. This can be helpful for tax purposes along the way, because it saves you from having to pay taxes as these shares vest until the point where you’re actually able to sell the shares to meet your tax obligations. That said, in the year of IPO, if everything accelerates and vests at once, be prepared for a hefty tax bill! We saw this firsthand with the Uber IPO. RSUs are taxed at ordinary income rates, but the IRS only requires companies to withhold at supplemental income tax rates or 22% for anything less than $1 million. This means that top tax bracket earners will owe at least 15% on the amount of stock vested (calculated as the difference between 37% and 22%).
What should I do with my vested RSUs and vested stock options post-IPO?
For people with Pre-IPO RSUs and stock options, when the company goes public, you will have a stake in your company. With the public markets involved, your decision making process becomes even more complicated, because (for the first time) you have to decide when to sell. As financial life planners, we’re trained to embrace the complexities and biases around financial decisions like these, and we’re prepared to show clients all of the ways that this is actually an amazing opportunity. Here, you finally have control over when you can sell. And just like we’ve already mentioned, this process only becomes easier and clearer with a solid financial plan. Studies of behavioral economics and finance show that investor behavior isn’t rational, because of the emotions derived from winning vs. losing. In the time frame that your company goes public, but you are subject to a lockup, you’ll have the chance to evaluate your divestment strategy from the company.
We encourage divestment, because there are a lot of ways to make money in this world. You’re already making money by working at this amazing company that just IPOed, but know that there are other amazing companies out there. Simply put - don’t put all of your eggs in one basket. The next section outlines three important steps you can use to kickstart your plan:
Step 1: Get financially organized
To get started creating a plan, you want to figure out how much you have invested in your company stock.
How many stock options do you have vested that are exercised & not exercised?
How many RSUs do you have?
If the company started to offer an Employee Stock Purchase Plan (ESPP), how many shares will you have from the ESPP?
Add up the values of your vested stock for the current year and what you expect you will have in each of the next few years. Compare this to your net worth. How much of your net worth is invested in your company?
The appropriate target percentage of net worth will vary by person. Let’s say you’re a young tech professional with tons of upside in your future earnings and limited financial responsibilities - it’s reasonable to assume that you can own more of your company stock than a seasoned tech professional with two homes, a family, kids in private school on the verge of college with limited liquid financial resources outside of their stock compensation.
Step 2: Build a financial plan
The next step is to figure out when you are going to exercise any options and when you are going to sell. We recommend reviewing your firm’s lockup calendar when establishing this plan and setting specific dates when you are going to place the trades. By establishing dates, you are more likely to stick to your plan.
If you have NSOs, there’s no issue with exercising and selling immediately. For ISOs, it’s in your best tax interest to get the clock started by exercising, but not exercising too much that it forces you to pay the Alternative Minimum Tax.
If you have a significant amount of company stock already, we recommend starting to sell as soon as you can. If you want to build a strategy that isn’t reliant upon a single day’s price, you can do a portion every month or quarter over 6 months to a year. Understand that the longer you wait, the more risk you are carrying in your company’s stock.
Step 3: Execute your strategy
For RSUs, you should either sell the stock with long term capital gains or sell the recently acquired RSUs that have not materially moved in price.
For stock options, you should consider the requirements for time frames to receive preferential tax treatment, as well as understand how your sale (or lack thereof) would impact your Alternative Minimum Tax Liability.
If you’ve agreed to sell a certain market value, you can optimize by considering long term vs. short term tax consequences.
The most important part of a stock compensation strategy is reinvesting the after-tax proceeds into what brings you the most joy.
Why have money unless it serves a higher purpose? It’s our goal as financial life planners to assign purpose to every dollar you have, including your stock compensation. We know that both understanding and planning for stock compensation can be complicated, and we want to remind readers that you absolutely don’t have to do this alone. There are many Certified Financial Planners and CPAs who are experts in this subject. We recommend working with a fee-only, fiduciary financial advisor to help build you a plan that optimizes your stock compensation strategy for your specific financial situation and life dreams. IPO is an exciting time in the life of a company and your own career, and we hope this blog helps demystify the options and strategies around its optimization.
If you have any questions, feel free to reach out.
Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.