How to Deal with IPO Shares that I Haven’t Exercised

This post is intended to provide general information only and should not be considered as personalized tax advice. We recommend that you consult with a tax preparer or a CPA about your particular financial situation.

Companies of all kinds offer stock options to employees. If you happen to have them, you may be asking yourself whether you should exercise your stock options or sit on them for a time and see what happens. 

In this post, we’ll teach employees looking to reap full benefits from their company's IPO about stock offering meanings, and we’ll provide tips so you have an idea of the path to take with your IPO shares.

But first, let’s understand what an IPO is and how it works.

What exactly is an IPO?

An initial public offering (IPO) is the procedure by which a private company first sells shares on the open market — this is also referred to as “going public.” 

Any investor can sell or buy these newly issued shares on a stock market, such as the Nasdaq or the New York Stock Exchange (NYSE).

How IPO works

Months of preparation are required before a private company can make its public debut.

The company engages an investment bank with an IPO underwriter to guide it through the process. Bankers examine the company’s finances and history to estimate its worth and target share price. Bankers are in charge of the regulatory paperwork required by the Securities and Exchange Commission (SEC) and public stock exchanges.

The underwriter also acts as a middleman between potential investors and the company in order to sell the shares and ensure their wide distribution. 

To generate excitement for the IPO, bankers and corporate officials hold so-called roadshows to pitch the stock to investment companies, mutual funds and other institutional investors.

The company creates a final prospectus, which is a document that describes the company’s business, financial position, prospects and dangers. The bankers submit the prospectus to the SEC and disseminate it to interested parties.

Deciding what to do with your IPO shares

Organize yourself

Now that you know how IPO works, check what you have available in your stock option grant agreements.

For example:

• Do you have nonqualified stock options (NQSO) or incentive stock options (ISO)?

• Are they vested or unvested?

• If they are vested, when do they expire? And assuming they do vest, how many will vest during the IPO, and how many will vest when the first trading window opens?

• What is the cost of exercising the option?

• Are there any double-trigger restricted stock units (RSUs)? How many of them are brought about by the IPO, and how long will it take for the rest of them to vest?

It’s a good idea to put all your notes on paper.

Go through and understand your grant documents

Each employee stock agreement will be accompanied by grant paperwork. These are the legal documents that your employer depends on to determine how your stock options will vest.

These documents will contain important information regarding when your RSUs would vest if an IPO occurs. They also lay out what happens if you move to a different company and how long you have to execute your stock options after you depart. It is critical that you read and understand them.

Obtain a copy of the trading calendar and take into account the stock price 

Once you’ve figured all of that out, it’s time to consider the stock price and whether it makes financial sense to move on to different possibilities right away. For example, do you know what the expected IPO price is?

If you do, you can compare it to the value of your vested RSUs and stock options to determine how much “income” you’ll have at the time of the IPO. It’s also a good opportunity to consider what price you’d be willing to accept for your shares.

Once you’ve determined this, consult your company’s trading calendar, which should show all of the times you’ll be able to sell your shares throughout the next year.

You may or may not decide to sell at these various times, but having those time frames in mind will help you with your financial planning.

When should you exercise your stock options: now or later?

When the IPO is announced, many people hurry to exercise their stock options. It’s easy to get caught up in the thrill of suddenly having a lot of money since your company went public and you can now sell your shares.

But, before you hurry to exercise, it’s critical to understand the tax implications.

Tax

Capital gains tax is classified as either short-term or long-term. In most circumstances, the length of time you own the item — the holding period — determines how the gain or loss is categorized for tax reasons. 

The holding period is critical because it influences your capital gains tax rate. Long-term ownership is encouraged under the tax system.

Determining your holding period

In general, if you own an asset for one year or less, you will have a short-term capital gain or loss. Your capital loss or gain is long-term if you hold it for longer than a year. 

To determine your holding period, begin counting the day after you purchase or acquire an asset. The day you sell the asset will be added to your holding period.

Short-term vs. long-term capital gains tax rates

As previously stated, the long-term tax rate for capital gains is significantly lower than the short-term rate. The tax rate on a short-term capital gain is the same as your normal income tax rate.

Regular tax rates, as you may recall, are progressive. For instance, if your $100,000 income is taxable and you are single, a percentage of your income will be taxed at 10%, 12%, 22%, and 24% as you progress through the bands. So, while you may be in the 24% marginal tax band, your effective tax rate would be in the ballpark of 18%.

Taxes can be either a cost or a source of return, depending on how you arrange for them.

Let’s assume you exercised your stock option long before the IPO and purchased a large number of shares at $5 each — when the fair market value (FMV) was $5 — with the expectation that they would someday be worth $100 apiece.

The beauty of this situation is that all $95 of your profit would be taxed as a long-term capital gain. 

However, if you had waited to exercise and sell at $100, you would have retained your leverage, but the $95 would be taxed as regular income instead. Essentially, short-term capital gains are taxed the same as your regular income whereas long-term gains are taxed on graduated thresholds with the average rate being around 15%.

Make sense of stock options and taxes

Here are a few more things to consider as you decide what to do now that your company has announced an IPO without you having exercised your stock options.

Be aware of RSUs

RSUs, or restricted stock units, are likely to be included in your equity grants and will affect your tax bracket, even if you haven’t done anything with your other stock options up to this point.

RSUs are taxed as ordinary income the moment they vest. This means that there is no way to use taxes as a source of return on your RSUs, and they don’t give you any leverage once they’re vested.

They can be a good source of immediate income in an IPO.

Nonqualified Stock Options (NQSOs)

These are considered the second-best source of capital in an IPO after RSUs. As a result, you may want to sell them after you’ve sold the RSUs.

Plan your NQSO purchases and sales with your existing tax rate. It may be advantageous to wait until your tax rate reduces, or until the FMV of the stock price rises and you can obtain more money from it.

However, exercising and retaining NQSOs comes at a substantial tax expense, and leverage, not taxes, may be your best source of return with these.

Incentive stock options 

ISOs are usually only offered to people who are in the top management of a company. These stock options come at a discounted price and may be treated more favorably when it comes to taxes.

Consider how many of these you can exercise before you are subject to the alternative minimum tax. Also, balance your plans for ISOs with your goals for RSUs and NQSOs. For example, your RSU may raise the number of ISOs you can exercise.

Determine your break-even point and then decide what you’re comfortable doing from there.

Final thoughts

If you haven’t exercised your stock options yet, it’s nothing to be worried about. You can still make a lot of money from your company’s IPO.

If you are looking to plan the best next steps for profitability now and in the future, and to get a better understanding of how IPO works, it’s important to seek the services of qualified financial professionals. 

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