The Instacart IPO has been delayed once again. So, what should employees with stock options do when their company’s IPO is postponed? It’s important to understand that the best practices around an IPO often focus on what not to do. If you have stock or options from a company about to go public, you might be tempted to factor in a future windfall into your current financial decisions. However, spending money you expect to receive before it actually arrives is risky. The current freeze in the IPO market also underscores the dangers of exercising stock options before an IPO.
In 2021, 1073 companies went public, but in the first half of 2022, only 92 companies did. This slowdown highlights the challenges investors face in timing their option exercises. Due to tax implications, liquidity issues, and market volatility, exercising options before an IPO might not be worth the risk. When you exercise options, the taxable spread is the difference between the strike price and the fair market value at exercise. This spread is considered ordinary income for non-qualified stock options or part of the alternative minimum tax (AMT) calculation for incentive stock options (ISOs). One of the main goals in any option exercise strategy is to minimize this spread.
While down markets can offer a tax-advantaged time to exercise options, the current IPO freeze highlights the risks of focusing too much on tax savings. One significant risk for people with ISOs is not having enough cash to pay the taxes due from the exercise. Exercising ISOs isn’t a taxable event for regular income tax, but it is for the AMT. The AMT isn’t triggered with every ISO exercise, but it can be if the spread is large enough and the shares aren’t sold by year-end.
Moreover, if the stock price drops, employees might end up with a taxable spread that exceeds the value of the shares when the tax is due or when there’s liquidity. This situation occurred last year, even when companies did go public. Many shareholders found themselves in a tough spot when the stock price fell, but they were still in a post-IPO lockup period.
For example, if an employee exercises ISOs in January, expecting the company to go public in March, they would have liquidity to sell shares in September after a standard six-month lockup. Selling shares could help avoid triggering the AMT, reduce the AMT burden, or raise cash to pay any taxes due. However, if the company doesn’t go public, the risk is triggering the AMT without having liquidity to pay the tax.
Instacart’s valuation has dropped almost 40% this year, which is likely to create issues for employees who exercised options and may have to pay taxes based on much higher valuations. Instacart isn’t alone; Chobani also put its IPO on hold before withdrawing it entirely. There are many other examples of high-profile IPOs being derailed this year.
Price volatility and uncertain liquidity timelines are major reasons to avoid spending money based on expected paper profits. Committing to higher lifestyle expenses, like buying a new house, with the expectation of a sudden wealth event can put you in a precarious financial situation due to the many unknowns.
Volatile markets also make it harder to decide when to exit a concentrated stock position. Deciding when to take profits is often challenging for investors with company stock, even those with significant gains. Even if you can’t sell yet, it’s important to be realistic about price targets, possible outcomes, and what you can and can’t control.
One strategy for planning to exit employer stock is to consider the base, best, and worst-case scenarios and assign a probability to each. Often, investors find the current price more attractive than they initially thought. Additionally, reducing risk doesn’t mean selling 100% of the position immediately. Diversification strategies might include dollar-cost averaging, limit orders, or using options on your options, such as a cashless collar.
There are many factors employees can’t control during an IPO, but how to allocate a windfall, when to exercise, and the approach to diversifying are within their control. For employees with stock options, the best approach is to stay vigilant and monitor potential changes. Weigh risk-adjusted opportunities to exercise and avoid making major financial changes before your financial situation actually changes.
If you need help managing stock options before an IPO or acquisition, please contact us today to schedule a consultation.