Understanding the IPO Process and Creating an IPO Investment Strategy

Aaron Szager, CFP®

Jul 21, 2020

Understanding the IPO Process and Creating an IPO Investment Strategy image

What to expect when you’re expecting (an IPO)

The Bay Area is ripe with risk, reward, success, and failure. Nothing embodies all of these words like working for or founding a tech company with the goal of going public through an initial public offering (IPO). Although there are certainly risks of going public, for many founders and employees this is the Holy Grail in tech; sudden wealth, cheap capital, prestige, validation, the ability to hire better talent, etc. As wealth advisors, our perspective is admittedly somewhat skewed as a result of mainly working with the success stories of Silicon Valley, many of whom have experienced the IPO process firsthand.

Such a life-changing event demands us to make highly consequential decisions such as when and how many pre-IPO stock options to sell, how to address the tax implications, which professionals to hire, whether to buy or sell a home, whether to stay with the company post-IPO, etc.  Initial public offerings  also cause a whirlwind of emotions such as elation, anxiety, and stress. We cannot emphasize enough the importance of preparing and planning for your company’s IPO, especially as it relates to your restricted stock units and stock options.

You may be thinking that there are a myriad of choices to make regarding your equity following an IPO. Unfortunately, for the first three to six months post-IPO you have only one choice: wait.


Planning Your IPO Investment Strategy

There will be a “lock-up period” that restricts all employees from selling their shares. This is one of the reasons why it’s not uncommon for a company’s share price to drop immediately following this period. Nervous employees wait through extreme volatility for months and sell a portion, or all, of their shares once the restriction is lifted. The main reason for the volatility is because there is no historical trading experience to establish “fair value.” In the case of many IPOs of technology and biotechnology firms (i.e., Uber, Lyft), the companies are not even profitable, which only increases the difficulty of establishing value, leading to uncertainty and share price volatility.

If you are considered an insider of the company (director, large shareholder, officer, board member, etc.), you will need to establish a written plan, pursuant to Rule 10b5-1, if you plan to sell your shares. The SEC introduced Rule 10b5-1 in 2000 in order to establish a clear way for those with access to material non-public information to trade their company stock safely without violating any regulatory rules.

To Exercise or Not to Exercise

If you have unvested options, most likely nothing will change. Your vesting schedule, number of shares, and exercise price will continue as-is under the newly public company.

In the case of vested options, the real benefit is that there will now be an active market into which you can exercise and sell following the lock-up period. After your options vest, as long as the market price of the stock is greater than the exercise price (otherwise known as “in the money”), there is a decision to be made: exercise and hold, or exercise and sell. The tax implications of exercising depend on whether your options are Incentive Stock Options (“ISOs”) or Non-qualified Stock Options (“NQSOs”), how long you hold the shares after exercising, and the date of grant.

Keep in mind that “exercising” is purchasing the shares at the pre-determined strike price so, if you do not immediately sell, plan on paying for the shares with outside resources.

RSUs are the most common and straightforward type of equity compensation. An employee is granted a specific number of shares that vest at some point in the future. In most cases, shares vest over a number of years. At the time of vesting, the value of the shares is considered ordinary income and taxes are due. This form of compensation works well with publicly traded companies, whereby shares are automatically sold in the open market and proceeds raised to pay federal and state taxes.

Herein lies the problem with receiving RSUs in a private company; even though shares are taxed as ordinary income to the employee, there is no open market into which to sell the shares. Even if a VC company or executives within the company agree to buy the shares, it is often extremely expensive to do so. If an employee owns vested or unvested RSUs in a private company, in most cases nothing will change post-IPO except there is now a publicly traded exchange into which you may sell your shares. It is important to review your company’s stock plan agreement that specifies what happens in the event of a merger, acquisition, or IPO.  You may receive the benefit of accelerated vesting of stock-based compensation under certain qualifying events.


Final Thoughts

As demonstrated above, there are many decisions that you will face as you approach a public offering. Understanding the IPO process and proper planning is crucial to make the most of your company’s IPO. Each case is unique and contingent upon the details of your stock plan agreement, which type(s) of equity compensation apply, and your position within the company.  Depending on your specific situation, an IPO will most likely warrant a comprehensive review of your financial life.  Not only has your personal balance sheet increased, but the complexity and magnitude of financial decision-making has as well.  How do you reduce taxes and avoid penalties and interest?  Should you reduce life insurance or increase umbrella insurance?  Is a donor advised fund or a foundation the best charitable giving structure?  How do you reduce or lower potential estate tax?  Have you reached a work-optional stage of life?  How would your financial plan be affected if we experience another recession?  Consult a Summitry Financial Advisor to develop a plan to take advantage of this very fortunate, most likely once-in-a-lifetime event.


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