Everything you need to know leading up to an IPO as a startup employee
Tech employees should understand how initial public offerings (“IPOs”) work and how they may impact the value of their compensation (particularly the equity component of their compensation).
This essay contains key pieces of information that will help you leave with an understanding of:
- The key events associated with the initial public offering (IPO)
- How an IPO impacts the value of your equity including tax implications
- Decisions you need to make to maximize your tax-home compensation
Most startups fail. Consequently, most personal-finance-advice-for-startup-employees says to value your equity at zero.
This advice is not helpful; it is particularly unhelpful if you work at a company that is rumored to be “going public” in the coming months because “HEY!”, you and your company have actually turned that lottery ticket into something actually valuable.
To note—rumored to be going public does not mean your company is actually going to go public. There are many scenarios where rumors leak about a potential IPO for years before any real activity starts. You should primarily look towards trusting your employer for information about any sort of guaranteed liquidity event. Consider the rest to be speculation (while useful, just make sure you do not treat things as fact).
What does going public mean?
Going public means being listed on public exchanges such as the NYSE or NASDAQ. An initial public offering is the process leading up to this listing. As an employee, you do not have to worry too much about the mechanics of the company going public, but you should recognize that it’s a labor-intensive effort that normally takes at least months and tons of coordination across many stakeholders.
What should my plan be?
Recognize that an IPO is a big milestone—it means the equity you have been working hard to make valuable for the past few years (or decades?) is about to finally* become something you can take to the bank (literally and figuratively in this context). It is also a rare event; most startups never make it this far so take a moment to congratulate yourself and reflect on the journey.
Now remember that you have already done a material portion of the work involved in maximizing the value of your equity—you have picked/created a company that is actually worth something.
In order to truly maximize the value of your take-home pay, though, it is important you build a “financial/tax plan” of sorts that ensures you are making thoughtful decisions.
Here is a playbook for maximizing the value thoughtfully:
1. Figure out what type of liquidity event is happening and any relevant details. There are many types of liquidity events that could be occurring. It could be a tender offer, entire acquisition, or some sort of public listing. There are two primary modes of “going public”:
- Direct Public Offering (DPO): A company can directly list itself via a direct public offering.
- Initial Public Offering (IPO): A company can go public with the help of investment banks by doing an Initial Public Offering (IPO).
There are several differences between DPOs and IPOs but the biggest difference to you as a shareholder is that DPOs generally do not have a lockup restriction, whereas an IPO, there will generally be a lockup period where you are not allowed to sell shares (something like 90 to 180 days after the public listing date). Having a lockup period can be problematic, especially if you are trying to diversify and the stock is moving with lots of volatility.
Leading up to the liquidity date, you will learn lots more information from your employer. This will sometimes be an overwhelming feeling, but hang tight because exciting information should be coming out soon. You will learn information about lockups. Those are especially important as it is very likely you will be barred from exercising your stock options in the days leading up to the liquidity event as well as following the event depending upon the nature of the listing.
2. Figure out the status of your equity today. Answer some of the following questions for yourself:
- Types of equity: You may have multiple forms of equity. You should be aware of all of the types and statuses so you can port that information into a more comprehensive cash flow plan that we will detail below.
- What type of equity do you have? Figure out the detail around stock options, shares, and grants as well as the vesting and exercise status for each. (Pay special attention to what percentage of your equity is already eligible for long term capital gains or qualified small business stock tax status versus what is not)
- Special note: if you have Restricted Stock Units (RSUs), you may owe taxes at the date of the liquidity event. RSUs for private companies generally have something called a double trigger taxation schedule, where all of the income you’ve earned as a function of the RSUs is taxed upon the second trigger (the first trigger is the vest event and the second trigger is some sort of material liquidity event). That trigger may be the date of the IPO, it may be the date of the lockup period expiring, or it may be some other function. You should figure out what trigger is yours, because you will owe taxes—immediately on that date—for any “income” you received from the RSUs. The income, in this context, is going to be any RSUs you have vested that will be taxed effectively as ordinary income. The rate for your ordinary income taxes depends upon your broader financial/income/tax picture. One option many companies allow you to do is actually sell a portion of your RSUs to cover the tax consequences (so you do not have to move money around elsewhere). This is a very common approach but please reach out to your employer and/or a tax advisor to walk you through things.
- Valuations: It is likely the 409A and preferred valuations will converge leading up to the IPO date.
- What is the latest 409A valuation/share for the company?
- What is the latest preferred valuation/share for the company?
- Who are the already public comps for your stock? How are they currently performing and how do you expect them to perform?
3. Understand what having an incremental amount of cash will do for your ability to achieve your financial goals. This is both a qualitative and quantitative exercise as you figure out what your income and expenses may look like in the future. It includes a number of estimations, but consider asking yourself (and potentially your partner, too), how would life look different if we had an extra $XM sitting in our bank account? What would you buy? What would you not buy? What would you invest in? What is important to you, your impact, and your legacy? Answering these questions so you can get an idea of the urgency of your liquidity needs will help you understand what your priorities should be.
We find a lot of people tend to be rather greedy during their first liquidity event in that they are afraid to sell their shares because they worry about the opportunity cost of their decision. What sometimes happens is they fail to realize just how meaningful an additional lump-sum of cash would be in their lives and for their families. We suggest, as we detail below, really pushing yourself on understanding the role money plays in your life (before you actually have the money) and seeing how that answer changes as you gain liquidity. Spending money is not inherently a bad thing—but we do advise folks to try and think deeply about their values and what is important as they ramp up their spend and investments.
4. Build a cash flow plan and scenario analysis. Take the inputs for your projected income and expenses and build out a series of cash flow scenario analyses. Build a variety of scenarios that detail the take home income across choices such as:
- Selling all your shares day one
- Holding all of your shares and exercising as many as possible as soon as possible
- Some combination of the two
Included in this plan, you will want to consider a few special elements such as:
- Tactics you can use to potentially save on taxes. A few that come to mind include a donor advised fund and a charitable remainder trust. You should work with a professional to figure out how to apply each of them to your situation.
- Changes that may happen in your life. Are you going to get married any time soon? Have kids? Move states? Change jobs? These variables will all impact your above scenario plans.
- Changes that may happen to your company. Is the company going in a new direction? Expanding internationally? Launching a new product? Is the industry evolving? These variables will all impact the potential value of your equity.
- Make a decision and write a memo. Once you have the data in front of you, all that is left is to actually make a decision (or more likely, a series of decisions that you will need to execute upon over time). We suggest you write yourself an essay detailing the decision and representing why you are making certain choices (as opposed to alternatives).
The above is a framework for thoughtfully maximizing your value heading into an IPO type event. It is important to remember that this is not the only way to approach the situation. But it is important to start somewhere so you can make a series of informed decisions. Additionally, it is important to surround yourself with advisors who can help you think through the nuances and specifics of your situation. We want to emphasize that being intentional here can make a huge difference in terms of minimizing long term regret.