Compound’s Guide to the IPO

For a startup employee, learning about your company’s initial public offering (IPO) is an exciting time. But it’s also overwhelming from a financial planning perspective. You have a variety of different equity grants, and you must decide what to do with each one. How many stock options should you exercise and sell, and when? What will your tax obligations be, and how can you minimize them?

This guide covers what a startup employee needs to know to make well-informed decisions about all of this. We’ll start with tax considerations around exercising and selling stock. Then, we’ll discuss strategies and timelines for selling stock after the IPO. Finally, we’ll go over ways to further minimize your tax burden after selling.

Money made from selling stock is taxed either as ordinary income (i.e. federalIn 2022, the federal tax brackets were: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Your bracket depends on your income and filing status; more details here. plus state In 2022, California state tax brackets ranged from 1% to 12.3%. New York state tax brackets ranged from 4% to 10.9%. Your bracket depends on your income and filing status. income taxes), or as long-term capital gains. If you acquire a stock (e.g. by exercising an option or vesting an RSU) and hold it for over a year before selling it, then your profit is classified as a long-term capital gain. Profits from stocks held for less than a year are short-term capital gains, and they’re taxed at the same rate as ordinary income.

Long-term capital gains are taxed at about half the ordinary income tax rate For unmarried individuals, the long-term capital gains federal tax rate in 2022 is: 0% for income below $41,675; 15% for income between $41,676 – $459,750; 20% for income exceeding $459,750. In California, though, you’ll have to pay additional state income tax on all capital gains (see sidenote 2). . So, in general, to minimize your tax burden, maximize your long-term capital gains.

Let’s look at how this plays out for ISOs, NSOs, and RSUs.

Your stock options represent the right to purchase shares of your company at a fixed price, known as the exercise price. You earn the right to exercise your options over time through a process called vesting, the timeframe of which is stipulated by a vesting schedule. There are two types—ISOs and NSOs—and early-stage companies will typically issue a mix of both to their employees.

For each tranche of options that you’ve been issued, be aware of three key numbers:

• Your strike price (aka exercise price): how much you pay to purchase each share.
• The 409A value (aka fair market value) of the shares, as of the time you exercise the options. For private companies, the 409A value is an independent appraisal of how much the private company’s stock is worth. After the IPO, this value becomes the company’s public stock price. Leading up to the IPO, the fair market value of your shares will likely rise greatly towards the company’s preferred price (or at least fluctuate). These fluctuations may greatly impact your tax calculations, and your company's finance team should keep you up-to-date on them.
• Your sale price: the price at which you later sell the shares.

On a high level, here is the difference between ISOs and NSOs:

For NSOs

• Pay ordinary income tax on (409A value - exercise price) when you exercise your options. So, if you pay $2 to purchase each share and the 409A value is $10, then you’re taxed on the $8 spread.
• Pay capital gains tax Depending whether you held the shares for over a year before selling them, you’ll either pay long-term capital gains or ordinary income tax on them. on (sale price - 409A at the time of exercise) when you sell the shares. So, if you exercise the shares when the 409A value is $10, then sell those shares for $50, then you’ll be taxed on the $40 capital gain.

For ISOs

• Pay no tax when you exercise—unless you trigger the AMT (details below)
• Pay long-term capital gains tax on (sale price - exercise price) when you sell—if the shares are sold at least one year after exercising, and at least two years after your options were granted. Otherwise, (sale price - exercise price) will be taxed as short-term capital gains (roughly ordinary income).

Upon exercising your ISOs, you will likely qualify for the Alternative Minimum Tax, or AMT. Back in 1969, 155 individuals with incomes over $200,000 managed to pay zero federal income taxes, triggering popular outrage. The AMT was introduced to prevent this from happening again.

The AMT is calculated based on the bargain element: the (409A value - exercise price). You owe AMT if:

1. Your total bargain value ( [409A value - exercise price] * total ISOs exercised ) exceeds the AMT exemption amount (which was $75,900 for single taxpayers For married couples filing jointly, the 2022 AMT exemption amount was $118,100. in 2022).
2. The tax you owe under the AMT calculation We won’t discuss how to calculate your exact AMT burden in this article, but it will come out to 26-28% of your total bargain value. exceeds the tax you owe under regular tax calculations.

You will have to pay AMT when you file your tax return for the year that you exercise your ISOs (it is not withheld at the time you exercise), so make sure to plan accordingly.

Upon exercising your ISOs, you pay AMT. Then, when you sell those shares, you’re taxed again on your capital gains. To lessen the blow of thus being taxed twice on ISOs, Congress introduced AMT credits.

Suppose you paid $5000 in AMT in 2019. In any subsequent year where you don't owe AMT (say, 2020), you might be able to get back some or all of that $5000. There are a few conditions for getting this tax credit:

1. You can't owe AMT in 2020.
2. The maximum amount of AMT credit you can claim for 2020 is [regular tax bill for 2020 - AMT amount for 2020]. After you claim your credits for 2020, any of the original $5000 that's left over can be used toward a subsequent year's tax deduction.

There are many other caveats that may warrant speaking with a financial advisor. But the bottom line is: you may want to try to strategically maximize the amount of AMT credit that you can claim later. Or, you can limit the number of ISOs that you exercise and stay below the AMT exemption amount (thus avoiding the AMT altogether).

RSUs turn into shares of your company’s stock when they vest. They’re typically issued by companies valued at over $1 billion.

RSUs are subject to either single- or double-trigger vesting. Single-trigger RSUs can vest before IPO. This means you’ll owe taxes on them as they vest (because you’re coming into ownership of new shares of stock). However, if the company is still private, you won’t be able to sell those shares to make money to pay the taxes you owe on them.

That’s why many companies instead offer double-trigger RSUs, which only vest after the IPO. That way, you’ll only owe taxes once the company is public and you can actually sell those shares. So, for the year that your company IPOs, be prepared to pay taxes on any double-trigger RSUs that you vest. Your RSUs may vest either on IPO day or after the lockup period, depending on the company.

When your RSUs vest (whether before or after IPO), you’ll owe ordinary income tax on the 409A value of your newly issued shares as of that day. As a reminder, the 409A value after IPO is equivalent to the company’s public stock price. Then, when you sell those shares, your profit (i.e. [sale price - 409A value as of the day the shares vested]) will be taxed as capital gains. Again, these qualify for long-term capital gains tax treatment if you hold onto the shares for over a year.

You can actually exempt your stock from all the federal taxes we’ve discussed above, if it counts as qualified small business stock (QSBS). Your stock might qualify as QSBS if:

• At the time that your stock was issued (i.e. when you exercised your options), your company’s gross assets did not exceed $50 million.
• You’ve held the stock for at least five years before selling it.

There are a number of other caveats. But, if you can get QSBS treatment, you’ll almost certainly save a lot of money in taxes.

With these tax considerations in mind, let’s discuss plans for selling your shares.

The soonest that you can sell your shares is after the lockup period. The lockup period lasts around six months, starting from the IPO date, and is meant to prevent employees from flooding the market with their shares (and thus lowering the stock price). This is generally true for traditional IPOs. If your company is going public via a direct listing, there might not be a lockup period. After the lockup period, employees generally employ one of a few selling strategies:

• Sell most of their equity immediately.
• Sell most of their shares as soon as they qualify for long-term capital gains tax treatment.
• Plan to sell a constant number of shares every quarter.
• Hold for the next decade.

Which of these (if any) is right for you? It really depends how much money you personally want to invest in your company. When you exercise your employee stock options, you’re investing cash in shares of your company’s stock. This is cash that you could have invested elsewhere—whether in your next startup, other stocks and bonds, or real estate. Likewise, after the IPO, you’re faced with a daily tradeoff: holding your company’s stock, versus selling it and investing the proceeds elsewhere.

Conventional wisdom says: diversify your portfolio; don’t invest too much of your net worth in one company. This is generally sound advice. But, before following it blindly and selling all your shares, think carefully about how much you believe in your company. Assuming that you continue working at the company, you can access more information about its business (and thus, in theory, better predict its stock prices) than the general public can. As a valuable employee, you may even have a non-negligible impact on increasing its share prices over time. These are all reasons to invest disproportionately in your company’s stock.

Do think critically, though, about how well your company may realistically perform in public markets. You should follow media coverage and popular sentiment around your company (and around tech IPOs in general); this will impact your company’s stock price. You can also look to other tech companies that have IPO'd recently, as well as any publicly traded competitors, to get a sense for how your company may perform in comparison. Research indicates that, historically, tech companies have tended to outperform non-tech companies in public markets in the three years following the IPO. Of course, this is a very general trend that should be taken with a grain of salt.

In addition to monitoring the risk and returns of investing in your own company’s stock, you should compare it to other potential investments. Investing in the public markets is one option. You could also look into average real estate returns in your area and consider buying a house. Angel investing is popular, though risky. Angel investing can be lucrative for experienced investors with large portfolios. However, roughly 90% of angel investing returns are produced by 10% of company exits. If you’re just writing a few checks to friends here and there, the odds that one of them will turn into the next Facebook are pretty slim. (Even if it does, it’ll take quite a few years for you to see any returns.)

Finally, consider your own career goals. If you plan to leave your company shortly after IPO, then you may want to cash out sooner. By leaving the company, you lose a unique perspective as an employee about the company, making it riskier to hold onto your shares. You also lose any unvested shares, which changes how your financial portfolio looks.

So, you've exercised and sold some stock, and your tax bill for this year looks pretty high. How can you further minimize your tax obligations?

A popular option is to move your money into a Donor Advised Fund. This allows you to receive a tax deduction while also donating to charity. At a high level:

1. You commit some amount of cash to charity.
2. You immediately receive a generous tax deduction for that year.
3. Your contribution is placed into a DAF account, where it can be invested and grow tax-free. You can grant this money to qualified charities at any point in the future.

Tax loss harvesting is another strategy. Let’s say that, this year, you lose $5000 on the stock market (i.e. you sell some securities at a total loss of $5000). Then, when calculating your total capital gains this year for tax purposes, you can subtract that $5000 loss from the capital gains you’ve made from selling your company’s shares. This can be especially helpful if it puts you in a lower tax bracket. You can carry losses from previous years into this year.

You could also move states—which may be especially appealing given work from home policies. Washington and Texas, for example, have no state income tax. There are a number of requirements, though, for establishing tax residency (e.g. needing to live in the state for at least 6 months). In general, capital gains are taxed based on your state of residency as of when you realized those gains. So, if you lived in California at the time that you vested or sold some shares, you’ll have to pay California state income taxes on those capital gains. Before moving, though, you should definitely look into the details on how your equity will be taxed for your specific state and situation. Beyond that, you can also take some time off of work to reduce your taxable income for the year.

At the end of the day, navigating an IPO is complicated. You can’t control the public’s perception of your company, but you can determine a thoughtful strategy based on your personal goals, preferences, and risk appetite.