Consider All Liquidity Event Outcomes When Creating Your Plan
Evaluate the tax implications of startup equity under different liquidity events to optimize your liability and types of gains or losses based on the exit.
Strategy Overview
When making decisions related to startup equity compensation, it's important to evaluate the tax implications under different possible liquidity event outcomes, not just one expected path. An IPO, acquisition, tender offer, and company failure can all have very different tax consequences in terms of timing, character, tax rates, and flexibility. Considering various scenarios allows balancing the tradeoffs to optimize your tax liability and types of gains or losses recognized based on which exit ultimately transpires.
Of course, predicting all outcomes and their probability is challenging; revisiting the analysis and your assumptions as the situation evolves is important.
Tax Details
The various types of potential liquidity events, such as an IPO, acquisition, tender offer, and company failure, can have very different tax implications that need to be considered.
For example, an IPO may allow gradually selling of shares over time to manage the amount and timing of recognized income. Meanwhile, an acquisition frequently results in immediate taxation via the sale of stock (if not a stock-for-stock deal) and/or buyout of equity awards. And a company failure may enable tax loss harvesting that can be valuable (though never having purchased your options would have been a better financial outcome). Some key items to consider include:
Timing. IPOs and some acquisitions (a stock-for-stock deal where the acquiring firm is publicly traded) can allow you to set your own schedule for selling to modulate tax liability, while tender offers, cash-based acquisitions, and company failures create defined tax events.
Tax character. The type of stock-comp holding that you have will in most circumstances determine the type of taxation you will owe.
Tax rates. Ordinary income can reach 37% federally, while long-term capital gains max out at 20%. Short-term capital gains are taxed at income rates.
Flexibility. IPOs provide the most flexibility; Acquisition flexibility depends on the deal type; tender offers are generally a binary decision (participate or don't), and company failures generally have no flexibility.
Considering potential outcomes allows balancing the tradeoffs to recognize ordinary income, long-term capital gains, short-term capital gains, optimize for QSBS (if applicable), as well as potentially be able to utilize certain tax strategies (from the 50+ tax strategies list) under different scenarios. This provides more options to modulate the tax liability and types of gains/losses based on the exit path.
An experienced tax advisor can help develop a dynamic strategy across all potential liquidity events.
Key Benefits
Avoid making decisions optimal for one expected path but suboptimal under other outcomes.
More informed decisions around exercise strategies and tax planning.
Key Considerations/Flags
Hard to predict and model all possible outcomes accurately for a private company.
Requires complex analysis to weigh tradeoffs across different scenarios. The process is typically time-consuming, and the multi-variate nature can make it difficult to model.
Requires strong tax expertise. Coordination with a tax advisor is recommended in most circumstances.
Detailed plans can quickly become outdated as company situation evolves. Requires ongoing reassessment.
Strategy: When to Consider This and When to Avoid It
When your company is pre-IPO (seed stage to Series E+)
If your company is publicly traded (the liquidity event has already occurred)
If you developed/aligned on a plan for your stock comp already due to other inputs. In this case, you've already made your decision
Example
Michelle works for a Series D company that she joined three years ago. She has multiple ISO and NSO grants, double-trigger RSU grants, and previously exercised some options in the past. The company is doing well, and tender offer, being acquired, and IPO are all liquidity events that are reasonable to believe could occur in the next couple years (as well as a company failure in certain scenarios).
As Michelle develops her plan for her holdings, she works with an advisor to develop a plan that considers the probability and estimated timelines for each outcome. When aligning on her plan, she and her advisor consider AMT impact (from the ISOs), QSBS (from her past exercises), capital gains and income tax across each of the possible liquidity event types.
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