When you work for a startup, IPO is an immensely exciting time. Executives and employees who have been receiving equity compensation may be looking forward to IPO day in anticipation of a big payout. Typically, however, company insiders aren’t allowed to sell shares at IPO. Even if it’s allowed, selling at IPO isn’t usually the best financial choice.
There are several reasons that startup employees can’t sell or may not benefit from selling their shares right away.
Lockup and blackout periods typically prevent employees from selling their pre-IPO shares in the early days following an IPO and at specific times when they tend to possess material, nonpublic information, such as before the release of earnings reports. The initial lockup period is commonly 180 days, but it can be longer or shorter than this. When a company goes public via SPAC acquisition, the lockup is often six months to a year.
Selling shares early can have negative tax consequences. No matter what type of shares you’ve received, you’ll need to hold them for more than a year to qualify for long-term rather than short-term capital gains rates. Short-term capital gains are taxed at the regular income tax rate, which tops out at 37% (Federal) for the 2024 tax year, while long-term capital gains are taxed at a maximum of 20%. As a result, selling while subject to short-term rates can be costly.
Employees who’ve received incentive stock options (ISOs) or qualified small business stock (QSBS) have even more to lose by selling early. The bargain element of ISO exercise (that is, the difference between the price paid and the shares’ fair market value) is not included in the regular income tax calculation when purchased—although it is included when calculating the alternative minimum tax (AMT). To receive capital gain treatment for ISO shares, they must be held for more than two years after the options are granted and more than one year after they’re exercised. Gains from the sale of QSBS are often eligible for 100% exclusion from income tax, but the required holding period is considerably longer to reap this benefit. QSBS shares must be held for five years and meet several other conditions for exclusion.
In the days, weeks, and even months following an IPO, a company’s share price can be subject to a great deal of volatility. If your company proves its value to investors over time, its share price could climb significantly after this highly unpredictable period. If you sell shares early, you will miss out on this potential growth.
Fortunately, there are ways to get cash from shares without selling them.
Margin loans, also known as portfolio lines of credit, allow shareholders to borrow against their shares. However, these loans involve a degree of risk. If the share price falls after you take out the loan, you may be required to provide additional collateral. This could force you into a difficult financial situation, especially if it occurs during a blackout period. While the SEC allows some hardship exceptions to blackout rules, they are narrowly applicable to unexpected and urgent needs for cash and must be granted by the company’s CFO. Because of these risks, it’s important to exercise great care in taking out margin loans.
Prepaid variable forward (PVF) contracts allow shareholders to avoid the pitfalls of margin calls while still accessing cash and retaining their shares. In this arrangement, a third party agrees to purchase the stock at a price to be determined in the future, based on the stock’s performance. The buyer, which is usually a financial institution, pays the seller a large portion of the shares’ value, and in exchange, the seller agrees to transfer a yet-to-be-determined number of shares to the buyer in a specified number of months.
The sale isn’t technically final until the contract’s settlement date. As a result, the seller can retain voting rights and satisfy holding periods while it’s in effect. Because these contracts allow sellers to deliver fewer shares if the price exceeds a certain threshold, sellers can continue to cash in on the future growth of a successful company. Frequently, PVF contracts include an option for paying the buyer in cash in lieu of shares. In this case, sellers who want to hold onto their shares after the settlement date can often take out another PVF contract, paying off the first one with the cash payment from the second.
Often, people who’ve received equity compensation want to get cash from their company shares so they can diversify their investments. Making the right choices involves looking not only at the expected performance of potential investments but thinking about how to maximize after-tax gains. That’s why it’s important for pre-IPO shareholders to work closely with a trusted wealth manager who can advise them not just about stock selection but also provide guidance for tax planning, sales strategies, and achieving long-term goals.
For more insight into making the most of your company’s IPO, visit WRP Wealth Management’s resource center or browse our blog.