ISO Planning/Strategy

Having/creating a plan for your ISOs improves your decision making

Pre-Read: Key Questions This Article Answers

• Should I exercise my ISOs? If so, why, and what tax impact will that have?

• What are the pros/cons of exercising (or not) my ISOs?

• How do I create a strategic plan for what to do with my ISOs?

• What tools/analyses should I conduct to help me decide what to do with my ISOs?

Developing a Strategic Plan For Your ISOs

Like most things in life, having a well thought out plan for your ISOs helps ensure you consider all (or at least the most important) factors, make better decisions, and minimize regret. You plan is unique -- to you, to your financial resources/needs/goals, to your company dynamics, and more. But the process to create a plan is generally somewhat straight forward:

1. Create a financial plan (if not done already). This gives you a well-considered "roadmap" for your financial life and goals. Your stock-comp can/may play an important role in this (depending on your situation), but your stock comp is an input to your financial plan (not vice versa)

2. Consider how your ISOs tie into/impact your financial plan. What is the current and potential future value of your ISOs, what are your financial resources and goals, and how can the value of your ISOs help you achieve your goals?

3. What are the key decisions you need to make?

   • What is the risk/reward of exercising (i.e. you're making an investment decision)?

   • What are the tax consequences of the decisions? And what choices and tradeoffs do you have to optimize for tax?

   • How can/should key inputs (such as company stage, business potential, liquidity, and life events) impact your decision making (positively or negatively)?

How Do Your ISOs Tie Into/Impact Your Financial Plan?

The value of your ISOs may be a tiny fraction of your overall net worth, or a larger percentage. The former would obviously impact your financial plan a lot less than the latter -> but tying your ISOs to your financial plan and goals should be the first step in your decisioning.

How to specifically "include your ISOs in your financial plan" can vary a bit, but every financial plan should seek to connect your life goals and your finances, taking stock of where you are today (i.e. financial resources and situation) and where you want to go (i.e. financial and life goals). Breaking that down:

(1) What is your current financial situation ("where are you today")

Understanding your current assets/liabilities and income/expense/savings rates are critical inputs for making decisions regarding your ISOs. Every situation is different, but generally:

• The larger your net worth is relative to the value of your ISOs -> the more risk you can "afford" to take (and vice-versa)

• The larger your savings rate is relative to the value of your ISOs -> the more risk you can "afford" to take (and vice-versa)

(2) What are your financial and life goals ("where do you want to go")

Connecting your ISOs to your financial goals is likely the most important of these two factors. As ISOs increase in value, they presumably will become a larger percentage of your total net worth. This is a good thing (i.e. your company's value is increasing, creating value for you via your ISOs), but as the number becomes larger, so does your concentration risk.

For example, we've seen situations where an individual desired to take investment risk (i.e. data point says exercise), and doing so would likely also reduce their tax burden (i.e. data point says exercise) -> but it wasn't in best service of their financial plan. The alternative (selling the ISOs and paying higher taxes) significantly reduced the household's risk profile and and allowed them to achieve nearly all of their financial goals with high confidence.

Said another way, your financial plan (and especially your financial/life goals) is your north star. And as such, you first need to consider "what impact would doing X have in helping me achieve my goals, versus doing Y". Every situation is different, and it's hard to make generalized statements for this item. But if doing one thing can materially (or significantly) change your progress towards your life goals and reduce your risk -> you need to strongly consider doing that (or more of that; it's rarely a binary choice), even if the investment and tax-optimization signals may suggest the opposite.

You Have Two Key Decisions to Make With ISOs

With ISOs, the two key decision you need to make are:

1. Should you exercise some/all your options?

2. If you have exercised, can/should you sell?

How you approach these two decisions can have a significant impact on your wealth, level of investment risk you take, and how you're taxed. Once again, the "right" decision is unique to you and your situation, but there are some key factors that can swing the pendulum in favor of one direction or the other:

Your Company Stage Impacts Pros/Cons of Exercising or Selling

Early Stage (Pre-IPO)

Early Stage Pre-IPO

Exercising ISOs earlier in a company's life has a couple of factors that bias towards Yes (all else equal). Selling shares (from ISOs) at this stage is uncommon (typically only via acquisition or Tender offer).

• Strike prices and AMT impact (if any) are typically lower in earlier stages, making the out of pocket cost to exercise shares typically lower

• QSBS eligibility is more commonly in play. Achieving QSBS has a number of requirements, but one that frequently invalidates purchases from qualifying is if the company has $50m or more in assets, and earlier stage companies less frequently have this amount of assets

Mid Stage (Pre-IPO)

Mid Stage Pre-IPO

Exercising ISOs in a company's middle stages is more circumstance based. Selling shares (from ISOs) at this stage is still uncommon (typically only via acquisition or tender offer).

• Strike prices and AMT impact (if any) will have risen, and a bias towards yes, no, or neither depends on the details. We recommend you conduct an analysis of the investments risks/rewards to aid in decisioning at this stage. AMT minimization strategies are likely also be applicable at this stage

• Some (but not all) mid-stage firms will have exceeded $50m in assets, invalidating the possibility of QSBS. If it's not been crossed, however (and no other factors invalidate it), then this is a factor that biases towards yes

Late-stage (Pre-IPO)

Late Stage Pre-IPO

Exercising ISOs in a companies later stages is the most circumstance based. Factors may exist that bias decisioning towards "Yes" or "No" (all else equal).

• Strike prices and AMT impact (if any) will have risen, and in many cases may bias towards a "Less" or "No". AMT minimization strategies are likely to be highly applicable at this stage

• Unique factors may also exist at this stage (e.g. a tax arbitrage opportunity between a liquidity price and the current 409A price), and should be considered

• In late-stages, liquidity is typically either anticipated or known. This is a key input to the overall risk of exercising/selling and should be a material part of the decisioning process

• We highly recommend one conduct an analysis of the investments risks/rewards to aid in decisioning at this stage

Public/Post-IPO

Publicly Traded (Post-IPO)

ISO exercise and sale decisions post-IPO have the most number of factors to consider.

• Option leverage. The closer an options strike price is to the publicly traded value, the more implicit leverage it has. This can definitely bias decisioning in one way or another depending on your planned strategy (buy/hold vs buy/sell)

• Daily investment risk. Publicly traded companies have stock prices that change daily, and you have the choice (theoretically) every day to sell or not (outside of lockups and blackout dates)

• AMT tax impact and optimization. AMT minimization strategies continue to be highly applicable at this stage

• Concentration risk. Some individuals think that going public is a sign of company maturity and stability. That's not necessarily incorrect, but most tech companies decline post-IPO. And even outside of tech and recent IPOs, most companies tend to underperform. As such, understanding and planning for your concentration risk is a major focus

• Selling plan development. Developing a selling plan and considering how to minimize regret typically leads to far better decision making for most individuals with ISOs post-IPO

• We recommend conducting an analysis of the investments risks/rewards to aid in decisioning at this stage

Business and Life Events Also Impact Pros/Cons of Exercising or Selling

Outside of your company stage, business and life events can also have a significant impact on your ISOs. For example, if you leave your company, you get divorced, or your company is acquired -> all can/do have major impacts on your equity compensation. We cover these items in depth on separate pages. For quick access:

• Liquidity Event Planning

  • IPO/Going Public

  • Tender Offer & Secondary Market Sales

  • Acquisition

• Changing Jobs/Employers

  • Company Departure

  • Choosing a New Company to Work For

  • New Employee Negotiation

• Life Event Planning

  • Death

  • Divorce

  • Marriage

  • Retirement

Tools to Help You Assess Investment Risk/Reward

We sound like a broken record, but your priority when decisioning should be (1) financial plan impact; (2) investment risk/reward; then (3) tax optimization. Some tools and data to help you assess the investment risk/reward are:

• A Simple (But Powerful) Way to Value Your Company. Once you've developed some estimates of what you think your company could be worth in various scenarios (and the probability of each scenario), it becomes a key input in helping you frame the risk/reward. Some key data to help you during this process is:

  • VC-Backed Company Exit Rates

  • Average Tech Company Post-IPO Returns

  • Single Company Stock Performance

  • Company Valuation Multiples & History

• Developing Your Divestment/Sale Plan (For Publicly Traded Companies). If your company is publicly traded, thoughtfully considering the different ways to manage your concentration risk and divest of your holdings is key to minimizing your regret

ISO Taxation & Strategies

• How ISO Taxation Works. An overview of how ISO taxation works

• ISO & AMT Tax Strategies. A guide to 8 different ISO and AMT tax strategies that may apply, depending on your situation and plan

• Income Tax Strategies. A guide to 9 different income tax strategies that may apply (given ISO disqualifying dispositions trigger income taxes), depending on your situation and plan