So your company IPO'd...

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Congratulations, you won! Not everybody gets to win the startup lottery, but it’s a pretty incredible feeling when it happens. There’s a whole bunch of things that are going to happen throughout this process, ranging from logistical mechanics of getting stock to a brokerage, selling stock, and owing taxes, so strap in for the ride.

What’s going to happen to all the stuff you’ve vested?

Depending on when you joined your company, you probably have either ISOs (which maybe you’ve exercised), shares (either you were a super early employee, or you exercised ISOs), or RSUs (usually you’re a later stage employee, probably somewhere north of the 1000-employee mark). You may have multiple of these classes of things. Also depending on where you fall along this spectrum, while an IPO is great for your net worth, it also means the IRS is going to be coming for its pound of flesh.

The important quirk here is around RSUs. For already-exercised shares, you’ve already dealt with tax exposure from exercising, and for options, you can sit around and hang onto those until you’re ready to sell (or exercise them ahead of the actual IPO, which would result in some potentially taxable event depending on AMT calculations). RSUs, on the other hand, don’t actually require exercising. When the vest, you just own them, but they’re not really stock, they’re restricted stock units, which is to say, kind of like stock. The restricted piece here is a useful indicator that there may exist some restrictions around these things, and the most important restrictions are qualifications that are commonly-known as “single-trigger” or “double-trigger”. If you’ve ever been an executive at a startup, you may be familiar with these terms, as they are also often used to describe acceleration schedules for option vesting in the event of getting acquired (and getting fired as a result of an acquisition), but the RSU definition is a little different.

Single-trigger RSUs are RSUs that you vest on a time-based schedule, similar to the standard four-year ISO vesting schedule, and once they vest, they’re just yours. This is actually somewhat disadvantageous for employees because when they vest, the IRS is all, like, “Hey you just made a bunch of cash, so it’s tax time.” The IRS looks at the fair market value of the company’s stock, the number of RSUs you just vested, and they say “that’s all income, and you owe us income tax on those earnings.” And then you might respond, “Oh, but Ms. IRS, ma’am, I can’t sell this stock yet, so it’s not really income at all,” and this oddly-anthropomorphized IRS simply holds out her hand for the tax revenues. Those earnings show up on your W-2 and all.

Double-trigger RSUs are the startup industry’s crafty way of solving this problem, which adds an additional restriction to the RSUs that they don’t compete vesting until an additional requirement is met, which is that there must be liquidity available for the RSUs, which is to say, you can sell the damn things. Typically this is defined using some language that specifies that the requirement is met when a change of control occurs (the legal term for an acquisition or merger) or something like six months after an IPO (because at the time of IPO you typically can’t sell, you have to wait for a lock-up to expire -- more on this later).

If you’re in the first camp with single-trigger RSUs, make sure you have cash set aside for taxes. They’re going to hurt the entire time you’re vesting. If you’re in the second camp, with double-trigger RSUs, you’re probably safe to hang on till the IPO, but be aware that as vesting happens, post-IPO, you’ll be taxed income tax at market rate for the RSUs. There’s no way to sit on the RSUs for a year to get long-term capital gains like you can with shares purchased via exercising ISOs.

So about these paper certificates…

Depending on how long you’ve been at your company, or when your company was founded, your exercised shares are likely either digital or paper certificates. Every exercise of options comes with an issuance of stock to you, and the evidence that you own those shares comes in the form of a stock certificate. If your company issues paper certificates, you probably have some of these that have been mailed to you, and hopefully they’re sitting in a safe place (like a safe deposit box or a fire-proof safe in your home). If you work for a newer company, there’s a good chance that your company manages their cap table (the ledger that details who owns each share of the company) digitally, using software like Carta or Shareworks. 

The first big step for you during an IPO is going to be getting those shares into a brokerage, where you’ll eventually be able to sell the shares. Fortunately, the company will arrange most of the details here. They’ll likely engage with a transfer agent or an escrow company (if you’ve never bought a house and aren’t familiar with the concept of escrow, they’re basically a company that exists just to be a trusted third-party that holds onto cash and funds during a monetary transaction to make sure everything goes down the way it’s supposed to). In the context of an IPO, these transfer agents do all the work of collecting certificates, getting them over to a brokerage, getting your account set up, and then dealing with the legal logistics of any lock-up agreements that may be in place.

The good news is that, for your purposes, the stock will basically just show up in a brokerage of the company’s choosing, you’ll get an account there (or link to your existing account with that brokerage), and you’ll be able to sell when it’s your turn. Generally pretty easy-peasy.

It’s IPO day, I’m rich!

Ok, not so fast. I’ve alluded to lock-up agreements in a couple places, and not to harsh your buzz, but the price on day one isn’t the price you’re going to get to sell at. Standard lock-up agreements restrict employees from selling shares for six months after the IPO. However, that’s not set in stone. Snowflake, for example, recently IPO’d, and has a very unusual lock-up schedule, which allowed current and former employees to sell up to 25% of their holdings after three months, and then had a second lock-up expire based on a floating target of the share price being a certain percentage above the IPO price for ten days, which allowed institutional investors to sell 25% of their holdings, and then all the stock will be unlocked at the six-month mark. Unusual, but it’s merely a legal agreement meant to protect IPO investors from the downside potential and intense volatility produced by insiders and early investors flooding the market with highly-appreciated stock.

As an employee, though, it can be a pretty rough ride. If your stock flies high, you’re going to be super excited, but it’s best not to focus on the day-to-day movements, as much as possible. If the stock is cratering, also probably don’t spend too much time watching the ticker. It will drive you insane. There’s nothing you can do but sit on your hands at this point and wait. 

The lock-up has expired! Time to sell everything!

Not so fast! If you’re an average startup employee going through your first IPO, there’s a good chance you are now in, what folks like to call, a concentrated stock position. There is a very high likelihood that the vast majority of your net worth is now tied up in this one stock, which leaves you in a precarious position. There are many strategies you can take to get out of this situation, and some of your options will differ if you’re still employed at the company, as versus if you’ve moved on, but most of your focus now should be to think through all the possible tax implications of your options, and make sure you’re making an intelligent, informed decision.

Here are a number of possible options for how you could dispose of this concentrated position:

Sell it all as fast as possible: If you think your company has peaked, or the stock is never going to get as high as it is now, or if the market it is in an extreme bubble, about to burst, this might actually be a good option. However, it’s going to mean an extremely large tax burden. If you exercised options throughout your employment, and you’ve held those shares longer than a year, you’ll get taxed at capital gains rates, which is advantageous. If those shares were held less than a year, this is all going to be taxed at marginal tax rates, and if you have a particularly large windfall, you’re going to be hitting 37% federal tax brackets. Also, if you’re one of the startup industry’s many California residents, it’s also worthwhile to know that California doesn’t have a concept of a capital gains rate, and their income tax is going to hit you for around 11-13% in addition to the federal rate. Expect to get to keep ~50% of every dollar you make in an equity sale.

Move to a different state: This probably sounds like a joke, and it kind of is, but it also kind of isn’t. Especially in the midst of a worldwide pandemic, with most companies allowing permanent remote work, moving states is a surprisingly legitimate tax management strategy. Obviously, it’s not for everyone. You might have kids, a mortgage, whatever, and moving is an extremely non-trivial action to take. But there are seven states that don’t tax income: Alaska, Florida, Nevada, South Dakota, Texas, and Washington. With Austin and Seattle becoming secondary tech hubs, there’s real movement to these tax havens as a tax management strategy. If you’re about to be taxed at California’s top rates, and you’ve made $1M on the stock market, moving out-of-state could save more than $100,000. That’s non-trivial money.

Sell at regular intervals, and set up your 10b5-1 plan, if you still work for the company: If you’ve never been through an IPO, it probably looks like I just referenced something from Star Wars. Not to be confused with R2D2, 10b5-1 plans are often crucial for people still employed at post-IPO companies, and get way more important the further you get into management and the leadership ranks. Every quarter, public companies report earnings, and most companies will impose blackout periods on their employees for a fairly long stretch of time before earnings are reported, and often for a few days afterwards. What this means is that during those times when the stock often makes the biggest moves, and is the most volatile, if you still work for the company, you can’t sell. The rationale is that insiders can’t trade on inside information. Pretty straightforward, and pretty reasonable. But it means that there are large swaths of a year when you can’t sell stock at your discretion. 10b5-1 plans are a great solution to this problem.

The way these plans work is by letting insiders set up a schedule: selling daily, weekly, quarterly, or defining specific triggers for sales like particular stock price points, and then putting the sales on auto-pilot. You can adjust the plans, but only outside of blackout periods. By doing this, the SEC attempts to ensure that you’re not trading on information about a particular impending event or other piece of information that would be otherwise unknowable by the general public or the efficient markets. The nice thing is that these plans also enable you to sell within blackout periods, since you don’t have any discretionary control to stop or initiate a sale. 

This is also a great mechanism to draw down your concentrated position over a period of time. There are lots of great analyses out there of hypothetical IPO situations, and examples of IPOs where you would have made the most money if you sold right at lock-up expiration, or waited ten years, or sold once a quarter for five years. Every IPO is different, and every strategy for exiting a concentrated position has to be customized to your personal financial needs and risk profile.

Diversification is key

My personal philosophy is that people should have well-diversified investments, across a variety of asset classes, but that the diversification strategy should match your personal risk profile. For example, I choose to work for startups and invest significant amounts of money into privately-held equity that might be worth nothing some day. I am willing to take that risk, because most of my investable assets are diversified across relatively low-risk asset classes. My retirement savings are as boring as you can possibly get. My 401(k) holds one fund: Vanguard Target Retirement 2055. 100% allocation.

I keep most of my assets boring, so I feel comfortable taking outrageous risks with equity related to my employment, and I’ve recently been sinking money into angel investments and weaseling my way in as an LP into various venture funds. However, it’s proportional to my total net worth. Maybe 5-10% of my net worth is in these more exotic asset classes, and most of the rest is in plain-Jane index funds.

The unfortunate part of an IPO is that it thrusts you head-first into an extremely risky investment allocation. When Cloudera IPO’d, I suddenly found somewhere around 50% of my investable assets in one single stock, and candidly, that stock has not done particularly well on the public markets over the past several years. However, I restrained my gut instincts to sell it all and get out, with the intent of trying to manage my taxes.

Tax-Loss Harvesting

The reality is that even the big gains can be managed down, if you’re careful. A critical strategy here is called tax-loss harvesting. This is not a new strategy, though it became much more common parlance as a result of the rise of robo-advisors like Wealthfront and Betterment, who offer tax-loss harvesting as an add-on to their basic service. The way tax-loss harvesting works is that when tax time comes, you can look at all the stock you’ve sold for a profit (called realized gains), and balance that off with stock that you sold for a loss (called realized losses). 

Realized Gains - Realized Losses = Taxable Income

Pretty straightforward, right? This is the core premise of tax-loss harvesting. It gets a little bit more complicated, however, because the holding period matters. You can’t offset long-term (held for more than a year) gains with short-term (held for less than a year) losses, and vice versa. You also can’t just sell a stock for a loss to realize those losses, and then turn around and buy it back to catch it as the price goes back up. This is called a wash sale, and the rule essentially says that you have to wait 30 days before purchasing the same stock again to treat it as a capital loss for tax reporting purposes. 

The IRS and SEC are actually even a little more specific about this, in that a sale is considered a wash sale if another stock or fund is purchased within 30 days that is “substantially similar” to the one that was sold at a loss. The way that robo-advisors get around this, without blowing up your asset allocation is that they’ve identified lookalike funds that have similar risk profiles and asset allocation, but are different enough from the other related funds that they won’t trigger wash sale rules. By doing this, they can periodically sell things at a loss to rack up capital losses, and then when they rebalance your portfolio, or you sell and withdraw funds, the total appreciation is lower.

Cost-Basis Strategies

This isn’t going to be as relevant if you have RSUs, but if you have ISOs, and you exercised options throughout your time at the company, the various dates and times when you exercised will result in different holding periods, and different cost bases for the various shares. The cost basis, as it pertains to ISOs, will typically be the strike price you paid for the shares. Importantly, however, if you paid AMT in the year when you exercised, your cost basis is actually the fair market value of the stock at the time of exercise (because you paid tax on the difference between the FMV and the strike price in the year that you exercised, and the IRS isn’t going to double-tax you on that). However, the brokerage holding your equity won’t know whether you paid AMT, so keeping good records of your taxes is extremely important for these cases.

These cost bases become really important, because when you go to pay taxes for the year, you pay tax on the difference between the sale price of the stock and the cost basis. You can also get really specific about which shares you’re selling when you report to the IRS (oftentimes you can actually do this through the brokerage, and specify a cost-basis reporting method that gets used when the brokerages generates 1099-B tax forms that describe your sales). So if you have 1000 shares with a cost basis of $1, and 1000 shares with a cost basis of $2, and you want to even out your tax exposure over time, and you want to sell 200 shares, you might choose to sell 200 shares and report to the IRS that 100 of them cost you $1, and 100 cost you $2. That way, your overall cost basis for the sale is $300. Thinking through the cost basis math allows you to be strategic about how much loss or gain you report, which can help minimize the amount of tax exposure in a particular year.

It’s also prudent to be careful about the specific shares you’re selling if you have been exercising options over time, and some of your shares have been held less than a year, versus more than a year. That’s a huge tax implication, and so it pays to be doubly careful when selling stock, to ensure that you’re reporting your earnings and holding periods appropriately. 

When in doubt, an advisor can help

This is one of those rare situations where I’d actually seriously consider getting a financial advisor. If doing your own tax planning and rebalancing of portfolios, isn’t your cup of tea, then get you a CFP who can do both. It’s more expensive in the long term, but might save you a bunch of money in the short term.