Pre-IPO: Key Decisions

Pre-Read: Key Questions This Article Answers

• What key decisions do I need to make/consider if I work for a pre-IPO company (e.g. Seed-stage through Series-E) ?

• How do I decide if I should exercise my ISO/NSO options if my company is pre-IPO?

• What tools exist to help me to better understand the pros/cons of exercising my ISO/NSO options if my company is pre-IPO?

Key Decision: Should You Exercise Your Options?

When your company is Pre-IPO, there are a handful of key planning items that most individuals are focused on: QSBS Qualification; Option exercise risk/reward; ISOs and AMT; Tax Optimization; Company Departure Considerations; and (if needed) financing the option exercise.

But nearly all of these stem from one primary decision: should you exercise (some or all) your options? This is a major decision that requires weighing several factors: financial resources, opinion of the company, tax implications, concentration risk, etc. There is no one-size-fits-all approach here; it's a decision that is unique to you, your finances, and your goals.

A Robust Framework for Decisioning (Four Key Factors)

There is a lot to consider when making this decision, and at times it can feel overwhelming -- which is why many tech workers end up opting to do nothing. And to be clear, wait/do nothing can many times be the right decision -- but that needs to be an active/intentional decision vs. a default "I didn't know what to do, so I didn't take any action" decision. To help individuals improve their decision making, our framework below breaks down the decisioning process four key factors:

(1) Can You Exercise Your Options?

Key Question	Impact
What are your financial resources to purchase the shares?	Generally, the more financial resources you have, the more you can afford to potentially do something (and vice versa)
Does your company allow early exercise of unvested options?	If early exercise is not available, this limits the decision to only vested options

(2) Should You Exercise (And How Do You Feel About the Company)?

Key Question	Impact
What is your opinion on the likelihood of an IPO and future stock price?	Exercising options is primarily an investment decision. We recommend using this framework, and this VC data, to help you better understand and model the potential outcomes

(3) What Are the Tax Benefits/Motivators for Exercising (vs. Not)?

Key Question	Impact
How much tax benefit do you anticipate by exercising and shifting taxes on gains to long-term capital gains tax rates?	The larger the potential/anticipated gain, the bigger the tax impact/motivator is. For more info: Tax Strategy: Exercise NSOs Earlier
Would exercising allow the shares to potentially qualify for QSBS (while waiting may invalidate it)?	Achieving QSBS qualification can provide a major tax benefit (e.g. potentially reducing total taxes from ~30% to 0%). For more info: Tax Strategy: Exercise Options Prior to a QSBS Disqualifying Event
Avoiding or reducing AMT if exercising ISOs.	AMT tax can surprise individuals when they exercise ISOs. Strategies to reduce/avoid AMT can be appealing. For more info: ISOs/AMT Tax Strategies

(4) Consider Liquidity, Option Longevity, and Employment Plans:

Key Question	Impact
Is a liquidity event expected soon?	An upcoming liquidity event can be a motivator or detractor for exercising, depending on the details.
Does the company have/offer an attractive post-termination-exercise-period ("PTEP")?	PTEPs provide you with additional time, decreasing potential motivators/needs to exercise.
How likely are you to leave the company in the next 6,12,24 months?	If you're likely to leave the company and have to decide to exercise or forfeit vested options, this will increase the need for a plan sooner vs. later.

Tools & Decisioning Frameworks

There are several useful tools and frameworks to leverage when analyzing the decision to exercise options pre-IPO.

Estimate your company's future value. Using our Simple (But Powerful) Way to Value Your Company framework can help you better understand and value your company. Everyone can/will complete this differently, but given exercising options is first and foremost an investment decision -> estimating how your company may perform can provide you with a more robust risk and reward framework to aid in your decisioning process.

Create financial outcome scenarios for your options. If/once you have modeled out your company's future value, you can apply portions of that framework to scenarios regarding your options. Considering variables such as number of options exercised and after-tax proceeds in each scenario can help illustrate which decision(s) may be worthwhile and which may not.

Conduct tax forecasting. With the scenarios you are considering, you (and your advisor) should likely be able to model out at least approximate estimates of taxes and after-tax cashflows in each scenario.

Financial Outcome Scenario Modeling For Your Stock Options (And Your Opinion Of The Company)

We recommend working with an advisor to ensure accurate tax projections

Examples

(1) ISOs & QSBS

Background

Johan, an early employee at UpUpUp Inc. has 60,000 ISOs ($0.50 strike; 15,000 vested; 45,000 unvested). A new VC raise is anticipated soon (Series B), and internal estimates are that the VC preferred price may be around $15.00 per share. The company current 409a is $2.00, and the unvested shares can be 83(b) early exercised if desired.

Johan is considering if he should should exercise his ISO shares prior to an anticipated Series B round, especially considering that the raise will likely be for $60m (after which any future purchases would not qualify for QSBS).

Key Considerations

1. Can you exercise. Yes; all 60,000 ISOs could be exercised. Johan has around $400k of savings and the company allows early exercise (for his unvested shares). Total cost if exercising all 60,000 would be $45k total ($30k to buy + $15k AMT bill).

2. Should you exercise/how do you feel about company. Johan strongly believes in the company and has a high investment risk tolerance.

3. Tax benefits/motivators. The AMT bill at the current 409a is much more palatable vs. what it will likely be after the Series B raise, and more importantly, exercising prior would possibly allow the shares to qualify for QSBS (if held for 5 years).

4. Liquidity; option longevity; employment plan. No liquidity event is anticipated for at least 3 years; Johan has no plans to leave the company anytime soon; no PTEP/extension exists for his grant.

Likely Recommendation

Johan should probably exercise most/all of his ISOs. His financial resources and risk tolerance make the out of pocket cost comfortably acceptable (and can tolerate a 100% loss). Tax-wise, exercising prior to the Series B when QSBS is still available and the AMT bill will be lower are big tax motivators. While recognizing that the odds of a large exit are statistically unlikely, Johan strongly believes in the company.

All in, Johan's financial resource/risk tolerance, his company opinion, and the tax motivators bias the decision in favor of exercising at this early stage

(2) NSOs with a PTEP

Background

Chen, an early employee at ZoomZoom Inc. has 40,000 NSOs ($4.00 strike; 15,000 vested; 25,000 unvested). The company's current 409a is $6.00, and the most recent preferred price (last VC round) was $10.00. Chen anticipates leaving the company in the next 12 months, and the company offers an option extension/PTEP of 5 years.

Key Considerations

1. Can you exercise. Partially; all 15,000 vested NSOs could be exercised; the 25,000 unvested options cannot be exercised via 83(b). Chen has around $200k of savings. Total cost if exercising all 15,000 would be $70k total ($60k to buy + $10k income tax/withholding)

2. Should you exercise/how do you feel about company. Chen strongly believes in the company and has a high investment risk tolerance.

3. Tax benefits/motivators. The tax motivator for exercising is that any/all additional appreciation above $6.00 would be taxed as capital gains (ideally long-term capital gains) versus taxed as ordinary income.

4. Liquidity; option longevity; employment plan. No liquidity event is anticipated for at least 3 years; Chen does plan to leave within the next 12 months; a 5-year PTEP/extension exists for his grant.

Likely Recommendation

Chen should probably do nothing with his NSOs. His financial resources and risk tolerance make the out of pocket cost acceptable (and can tolerate a 100% loss). However, the motivator for exercising (improved tax rate on additional company appreciation) is relatively small compared to the risk (loss of 100% of his investment). Considering that a 5-year PTEP exists, allowing Chen to maintain his economic exposure to the company for a significant period of time without paying any money out of pocket, the risk/reward dynamic heavily favors doing nothing.

(3) NSOs with Upcoming IPO

Background

Mei works at Space Mining Inc., and has 40,000 NSOs ($4.00 strike; 12,500 vested; 27,500 unvested). The options cannot be early exercised, but do have a 5-year PTEP/extension. The current 409a is $6.00 and the most recent VC preferred price is $10.00. It is anticipated internally that Space Mining will go public via an IPO within 12 months, and internal rumors suggest the price per share would be around $25.00. Mei has no near-term plans to leave the company.

Key Considerations

1. Can you exercise. Yes; 12,500 NSOs could be exercised (but not the unvested 27,500). Mei has ~$150k of savings. Total cost if exercising all 12,500 would be $58k total ($50k to buy + $8k for taxes).

2. Should you exercise/how you feel about company. Mei modestly believes in the company and has a medium risk tolerance.

3. Tax benefits/motivators. The tax motivator for exercising is that any/all additional appreciation above $6.00 would be taxed as capital gains (ideally long-term capital gains) versus taxed as ordinary income. Especially considering the upcoming IPO.

4. Liquidity; option longevity; employment plan. An IPO is anticipated within 12 months; Mei's options have a 5-year PTEP; she anticipates staying at Space Mining Inc. for the foreseeable future.

Likely Recommendation

Both sides could be reasonably argued in this scenario. If things play out as currently anticipated (i.e. Mei can sell the shares in 12-18 months post IPO for $25), Mei would likely save 10-12 percentage points on taxes by exercising now vs. later; a cash benefit of around $24k to $29k ($25 - $6 = $19/share *12,500 shares * 10%-12%). There is considerable risk to this scenario however; the IPO may not occur, or the post-IPO price Mei is able to sell at could be considerably lower than the $25 forecast.

Taking into account Mei's modest belief in the company and medium risk tolerance, our recommendation would likely be that Mei does nothing. While the potential tax savings are significant and the planned liquidity (IPO) event decreases the risk of illiquidity somewhat, many things can go wrong and a very significant risk of loss still exists.