In reviewing Pinterest’s S-1 IPO filing, I noticed something unusual: Ben Silberman, founder and CEO, had 31.2 million vested and unexercised stock options in his company. While those options on IPO day would be worth a fortune of roughly $750 million, they would also likely carry a tax bill $150 million higher than what it could have been.
To me, this subtle detail jumped out of the filing because it was a financial planning omission that I had experienced myself (albeit on a much smaller scale) with my stock options in the early days of Compass. Equity in a high growth private company can be an extremely valuable asset; however, more so than many other types of investments, effective planning can have a large positive impact on the ultimate net value of an employee’s equity.
As an increasing number of companies leverage equity to incentivize their employees, it is worth ensuring that entrepreneurs and employees who hold equity fully understand their choices and the potential consequences.
The Equity Playbook
Startup equity can take many forms, which are not all treated equally by the IRS. Knowing exactly what one holds is key in unlocking the full potential value.
The typical startup’s issuance of equity begins with restricted common stock to its founding team. That stock would usually vest over several years, with the employee potentially owing taxes on the value of the equity as it vests. That gradual and increasing tax exposure can and should be pre-empted by making an 83(b) tax election. This election allows the recipient to be taxed on the full upfront amount at issuance, which typically is a nominal amount, given the early stage of the company, as opposed to a potentially higher valuation later on.
Once the company is legally formed, employees generally receive their equity in the form of stock options. These options have an exercise price which the employee must pay in order to convert the options to stock. If the company permits an early exercise and the share price is low enough, exercising the options enables three benefits:
1) Pay no tax until the shares are sold
2) Qualify for long-term capital gains if the stock is sold for a profit after >1 year
3) Potentially qualify for the Qualified Small Business (QSB)exemption and receive up to $10M in gains free from federal capital gains tax (if the stock is held for five years and the company is eligible)
The drawbacks to an early exercise include having to outlay the entire cost to exercise while the timeline of a return is not guaranteed. Employees should note that if they do not exercise their options but depart the company, they typically have to exercise within 90 days or face losing the options.
If an employee exercises and the company fails (or gets sold for a fraction of its earlier value), the loss of funds used to exercise can offset other investment gains.
As a company’s valuation grows and the business gets closer to a potential exit, some companies will rollout restricted stock unit (RSU) plans. For employees, the advantage of receiving RSUs is there is no exercise cost; however, the full value is taxed as income, which is a much higher rate (often more 40%) than long-term capital gains (~20%).
So, what happened to Ben from Pinterest? In his case, he received early stock options but did not early exercise them. Had he exercised the options when received 6 years prior, the gain would have been taxed at long-term capital gains rate, ~20% lower than income tax rates.
Enhancing the Outcome
When a company reaches a liquidity event there are an additional set of considerations. For standard public IPO listings, employees typically reach their first opportunity to sell after a 180-day lock-up. Several important factors should be evaluated in determining:
1) When to sell and how many shares to offload:
- Diversification: It’s not a good idea to be too heavily invested in any one company, especially that one also provides someone’s paycheck. If the company faces financial trouble, the equity holder could end up out-of-work and with an investment that plummets in value.
- Tax implications: The sale of company stock can push the seller into a higher tax bracket, resulting in a substantial tax bill. Managing the timing of sales and their expected tax implications can yield incremental benefit.
- Timing: Stock prices are often volatile after an IPO. It’s best to develop a long-term strategy to harvest the maximum gains and minimize the risk of price drops.
2) Additional tax-savings strategies:
- Donating equity to charity avoids tax in selling the shares and allows for a tax deduction
- Creating a donor advised charitable fund allows one to gift a portion of equity or cash upfront, receive the tax deduction that year and then give away the money over several years
- Creating a tax-advantaged trust, typically by transferring company stock to a trust before the market value increases can be efficient if you plan to gift value to children
- Gifting stock to family members
For those fortunate enough to have personal and professional work translate into a successful company IPO, it is worth ensuring that the right financial, tax and legal planning is undertaken at the correct time to avoid the feeling that not acting carried a large, painful price tag.