30 May 2023
Pre-IPO stock options are a potentially lucrative and sought-after form of equity for company employees and well-positioned individual investors. Usually, the excitement created by a company going public is enough to guarantee a smart payday for anyone who already owns these shares. How can you get them what makes them unique?
In brief, a pre-IPO stock options issue is where a private company offers a specific group of people the opportunity to buy pre-IPO equity at a specified future date. Pre-IPO share options are issued by companies headed toward an IPO event in the near term. They are usually offered to early employees, VC firms, and individuals affiliated with the company in some way.
Pre-IPO stock options have a lot of significance in the business world specifically in the startup world. One of the reasons they exist is to offer targeted parties an opportunity to benefit from an IPO event. They are also used to incentivize early employees, retain talent and offer liquidity. We shall discuss all these topics in detail later.
There are so many guides on the web discussing the concept of pre-IPO stock options but they are all full of financial jargon. In this post, we discuss pre-IPO stock options in detail using simple language and in an easy-to-read format. We’ll help you understand pre-IPO offers, who can get pre-IPO options, how to exercise your options, their pros and cons, how to grow wealth with them, and much more.
Let’s get right into it!
Contrary to common assumptions, pre-IPO stock options are not company shares, per se; in fact, they are not even worth a penny! The concept of pre-IPO stock options refers to where private companies give a select group of individuals an offer to buy a percentage of the company at a future date pre-IPO. Think of it as a company telling you that you are welcome to own a piece of the company before everyone else.
Pre-IPO stock options are unique because they are offered at a predetermined price- also known as the exercise price or grant price- which is potentially advantageous to the person who exercises them. Most companies offer pre-IPO stock options as a form of alternative compensation. The practice has gained popularity in recent years with at least 80% of pre-IPO companies offering pre-IPO stock options.
The target group for pre-IPO stock options is mainly company employees or individuals who are closely affiliated with the company. For a long time, many companies offered stock options to executive-level employees but nowadays, nearly every other company is issuing them to all eligible employees. Sometimes, companies offer stock options as part of the recruitment negotiation package.
There are three main types of pre-IPO stock options common in the current market distinguished by their nature and target group. Perhaps the most common and basic type of pre-IPO stock option is the ISO- Incentive Stock Option. Nearly two-thirds of pre-IPO options are offered as ISOs although their prevalence varies from industry to industry.
The three common types of pre-IPO stock options are ISO, NQSOs/NSOs, and RSUS. Here is a simplified explanation of each of them:
ISOs (Incentive stock options) also known as qualified stock options are a type of pre-IPO stock option offered to employees as a way of incentivizing them, rewarding or as a way to retain them. In very unique instances, ISOs are offered to very talented workers to recruit them. Talented workers like programmers can overlook the below-average salary offered by promising startups if the ISO offer is attractive enough.
Incentive stock options are eligible for special tax treatment when specific conditions are met. For instance, they attract a favorable capital gains tax when exercised or liquidated after a vesting period. However, there are instances where exercising them may attract a special tax known as the Alternative Minimum Tax (AMT). Ensure you consult a tax expert to avoid attracting a huge tax bill when exercising or liquidating your ISO equity.
Companies tend to impose certain restrictions on ISOs outlined in the option contract. The restrictions are designed to help align the ISOs with the company’s long-term goals and objectives. A good example of such a restriction is the vesting schedule which restricts the time window you can exercise your options. Resigning or being fired can mean losing stock options in certain circumstances.
As an example, let’s assume you are an executive at company X. Company X wants to reward you for being a loyal employee or to incentivize you to stay with them. They can do this by offering you a chance to purchase the pre-IPO stock in the company at a set rate known as the grant price.
The grant price or exercise price on most ISOs is usually pegged to the fair value of the company at that time which means you stand to gain as the company’s valuation increases over time. You can “buy” the company’s stock at that price as soon as it vests and later liquidate it when the company goes public, sold, or merges with another company.
Eligibility: ISOs are usually offered to employees only and are subject to certain eligibility criteria, including minimum employment periods.
Tax Treatment: One of the significant advantages of ISOs is their favorable tax treatment. Employees do not need to pay regular income tax upon exercise, provided certain conditions are met. Instead, they may be subject to the Alternative Minimum Tax (AMT) when they sell the shares.
Exercise Price: ISOs must have an exercise price equal to or higher than the fair market value (FMV) of the stock on the grant date. This helps ensure that employees gain value from the stock’s appreciation.
Holding Period: To qualify for the favorable tax treatment, employees need to hold the shares acquired through ISOs for a certain period, usually one year from the exercise date and two years from the grant date.
The second common type of pre-IPO stock option is non-qualified stock options. These are pre-IPO stock options offered to employees and select external stakeholders at a set price. They mainly differ from ISO because they don’t enjoy tax advantages and can be granted to outsiders like consultants. NQSOs, also simply referred to as NSOs attract income tax when exercised which is pegged on the difference between the stock’s fair market value and the exercise price.
NSOs are generally regarded as a more flexible form of pre-IPO stock offer for two key reasons. The first is the fact that there are fewer restrictions on who can receive them. NSOs can be given to select outsiders and employees who don’t meet the strict requirements usually found in ISO contracts. Secondly, NSOs are non-statutory options and attract income tax when exercised.
You will still benefit from your NSOs if the company’s value increases over time even though the taxes are higher. Generally, most people who hold NSOs have an upper hand by making money based on the company’s performance over time and during a liquidation event. NSO holders are usually closely connected to the issuing company or employees who do not qualify for ISOs.
Eligibility: NSOs are not bound by the same strict eligibility criteria as ISOs. They can be granted to employees, consultants, directors, and even outside investors.
Tax Treatment: NSOs are subject to ordinary income tax upon exercise, based on the difference between the exercise price and the FMV of the stock on the exercise date. This means employees will generally pay higher taxes at the time of exercise.
Exercise Price: NSOs do not have the same exercise price restrictions as ISOs. The exercise price can be set lower than the FMV of the stock on the grant date.
Holding Period: There is no specific holding period requirement for NSOs to receive favorable tax treatment. Employees can sell the acquired shares immediately after exercising, but any further gains will be subject to capital gains tax.
The third pre-IPO stock options type is Restricted Stock Units (RSUs) Which are pre-IPO stock options offered as compensation to employees. RSUs are unique because they represent the real shares of the company, not an exclusive allocation of shares that you need to buy with your own money. When a company allocates you RSUs, they are promising that you will receive that exact amount of shares in the future.
You might ask, if RSUs are already allocated to you and you don’t have to buy them what is the catch? Well, like the other pre-IPO stock options, RSUs are subject to restrictions outlined in the RSU contract. Standard restrictions for RSUs in most industries are pegged on employee performance within a given vesting period.
Upon the lapsing of the set vesting period, the company will allocate you the exact number of shares in the RSU. Keep in mind that RSU shares appreciate or depreciate based on the company’s performance which means you will always have some money unless the company goes bankrupt and is unable to meet its pre-IPO obligations in totality.
Restricted Stock Units (RSUs) are treated as taxable units when they vest (when you receive them as shares). Similar to NQSOs, RSUs are treated as income and therefore subject to income tax which is usually withheld by the issuing company (withholding tax). They are also subject to capital gains tax when sold post-IPO and may also attract the Alternative Minimum Tax (AMT) in some conditions.
One important detail to be aware of when considering all types of pre-IPO stock options discussed here is their liquidity. Most companies have restrictions on the issuance, exchange, or sale of all pre-IPO stock options which affects their liquidity in the short term. The vesting schedule, for instance, restricts when you can exercise your options or when you will receive promised shares for RSUs.
More importantly, most companies have strict restrictions on the transferability of pre-IPO stock options because they want control over their ownership structure. Remember also, that these options are used to reward or incentivize employees so easy transferability could be counterproductive. Lastly, you can only liquidate exercised pre-IPO shares after the lock period in case the company goes public.
Eligibility: RSUs are often granted to employees at various levels within a company. While they are commonly offered to executives and key employees, eligibility can extend to a broader range of employees depending on the company’s policies. Unlike stock options, RSUs are not exclusive to employees; they can also be granted to consultants, directors, and other non-employee stakeholders.
Tax Treatment: Vesting Period: RSUs typically come with a vesting period during which employees must wait before they can receive the shares. Once the RSUs vest, they convert into actual company stock, and the value of the shares is included in the employee’s taxable income.
Withholding Taxes: Upon vesting, the company may withhold a portion of the shares to cover taxes. This withholding is often done at the statutory withholding rate or another predetermined rate.
Capital Gains Tax: When RSU shares are eventually sold, any gain in value is subject to capital gains tax. The tax rate depends on whether the shares were held for a short-term (less than a year) or long-term (more than a year) period.
Exercise Price: Unlike stock options, RSUs do not have an exercise price. Instead, RSUs represent a promise to deliver company stock to the employee at a future date once the vesting conditions are met. The value of the RSUs at the time of vesting is usually based on the fair market value (FMV) of the company’s stock.
Holding Period: While RSUs do not have an exercise price, they often come with a holding period. This is the period during which employees are required to hold onto the shares before selling them. The holding period can be specified by the company or determined by individual tax strategies.
Long-Term Capital Gains: Holding RSU shares for a specified period, typically more than one year, may qualify employees for a more favorable long-term capital gains tax rate when they eventually sell the shares.
Here are the most common terms and concepts you need to know when it comes to pre-IPO stock options in no particular order:
Pre-IPO is a term used to refer to the period before a private entity formally goes public via an Initial Public event. During this period, the company’s ownership is still private and owners could be founders, venture capitalists, employees, or a mixture of all these people. The term pre-IPO implies that the company plans to go public at some point in the future.
In the context of pre-IPO stock options, vesting is the process by which held ISOs, NQSOs or RSUs become available to you as the holder. Vesting may occur over a period or once depending on the conditions set on the pre-IPO stock option contract you signed. The two common types of vesting are performance-based vesting and time-based vesting.
Stock options in the context of pre-IPO stock options are financial instruments that grant you the right or promise to buy a portion of a company’s equity (shares) at a set price and in a pre-agreed time frame or based on you meeting set conditions as the holder.
The exercise price in pre-IPO options is the pre-determined price at which you can buy the stock options you were given before they vested. It is called an exercise price because the act of buying or claiming the pre-IPO stock options is called “exercising” in the pre-IPO world. Companies have internal financial formulae and approaches for the exercise price but the idea is to discount it so the holder can have a financial gain upon “exercising” the options.
Strike price- The strike price is a synonym for the exercise price in the context of pre-IPO stock option investing. It is also known as the grant price to refer to the period that the holder is “granted” the pre-IPO stock options.
The term strike, however, is usually used to refer to the act of choosing the appropriate period within the vesting window to exercise your options to maximize gains. This could, for instance, be the period just before an IPO when you know the price is going to rise.
A vesting schedule in pre-IPO refers to the timeline which contains conditions about how option holders can exercise their options or claim ownership rights of pre-IPO stocks in the case of RSUs. Vesting schedules are drafted by the company offering options that are meant to protect the company’s interests and make the options more effective.
The standard practice in most industries is to have gradual release vesting schedules where you get to exercise your options over a period. Gradual release vesting schedules are typically created as a retention mechanism as opposed to a financial mechanism. The idea is to encourage employees who have stock options to work remain with the company over the long term.
For instance, graded vesting schedules typically allow a set percentage of stock options to become vested over a period. In such a schedule, you can, for instance, have a ¼ of your options vest after a year of working with the company and another the second, and so forth. Alternatively, a “cliff” vesting schedule makes a set amount of options to become fully vested after a period.
A Liquidity event in pre-IPO land is a significant event for options holders. It refers to an occurrence that allows you as the holders of pre-IPO shares to liquidate them (sell them for cash). There are several types of liquidity events, such as IPOs, mergers, buybacks, acquisitions, or secondary market selling opportunities (where allowed). Please note that you are not obligated to sell your pre-IPO shares in all liquidity events save for a few such as buybacks or acquisitions.
The exercise period is a critical concept that you need to be aware of when it comes to pre-IPO investing. It refers to the time window or timeframe where you are free to buy the stock options you hold so you can get real shares. Exercise windows are set in the option agreement or contract and can last between a few months to several years depending on the vesting schedule.
One thing you should note is that failure to buy the allocated shares in the exercise period invalidates your stock options. Remember stock options do not belong to you even after they vet and are worthless if not exercised. Exercise windows do not apply to RSUs because you already allocated shares and will receive them as soon as they vest.
As attractive and rewarding as they are, pre-IPO stock options are not available to every other investor with a bag of cash. Generally, it is not common to find a non-employee or outside being allocated pre-IPO stock options. Secondary markets for pre-IPO stock options and share do exist but they are not as accessible as the public share markets in most jurisdictions.
There is no standard law managing the issuance of pre-IPO stock options in private entities. This means you cannot, under any circumstances, demand to be allocated stock options in any company under the laws. Private companies are free to come up with their eligibility requirements for pre-IPO stock option allocations.
That said, the following are the standard eligibility requirements used for the granting of pre-IPO stock options in most companies:
In some companies, certain types of pre-IPO stock options are issued to employees who have reached a certain level in the hierarchy. For instance, it’s common practice for companies to grant Incentive Stock options to high-level company executives, senior engineers, and top managers. They are given these ISO as a retention incentive as their contribution is key to the company’s continued growth and success.
In some companies, you will be offered pre-IPO stock options if you are a current or incoming employee as a form of motivation, reward or a form or compensation. It is very common in industries with stiff competition for talent for promising startups to offer attractive stock options to new hires or prospective hires so they can compete with established companies.
Employment-based eligibility for pre-IPO stocks typically locks out external stakeholders like consultants, suppliers, and contractors. The conditions or restrictions imposed on the issued options also tend to be stiffer as they are designed to advance the issuing company’s interests in the long run.
In some cases, employment-based eligibility is used to lock out certain types or classes of workers. For instance, it’s not uncommon for companies to only issue pre-IPO stock options to full-time employees, thus locking out contractors, remote workers, and temporary workers. This might seem unfair but you can appreciate the reasons behind these restrictions with job fluidity in mind.
Some companies require a person to have worked for the company for a set period before they are offered pre-IPO stock options. For instance, they may require that you work for the company for at least a year as a full-time employee or consultant before you can get the pre-IPO stock options. The requirement is meant to ensure the employees are committed to the company and have met the minimum contribution threshold.
Tenure-based eligibility is not common as it can typically be implemented with the vesting schedule after the pre-IPO stock options have been issued. However, it is commonly used to qualify to select external stakeholders and temporary workers like contractors for non-qualified stock options (NSOs).
In some industries, companies use employee performance to determine eligibility for pre-IPO stock options. In such cases, the stock options are given to reward employees or other people based on demonstrated ability to meet and exceed individual performance goals. This can also be implemented through a performance-based vesting schedule.
In granting pre-IPO stock options, companies may also consider compliance with applicable securities laws and IRS codes to determine eligibility requirements. Compliance with Internal Revenue (IRS) Code Section 409A is critical when determining whom to allocate non-qualified stock options (NQSOs). At the same time, individuals must be vetted and be found to be compliant with applicable federal securities laws especially where external parties like foreign contact workers are involved.
Private companies have varied ways of allocating pre-IPO stock options mainly based on the amount and value of shares available, company size and profile of the company, and internal policies regarding equity distribution. For example, a company could decide to allocate 30% of company equity to its employees with the amount of pre-IPO stock options allocated to individuals varying based on other factors.
That said, the allocation of pre-IPO stock options follows certain standard rules designed to ensure they serve their purpose and do not hurt the issuing entity. Standard allocation methods used to allocate pre-IPO stock options include:
Companies often allocate pre-IPO stock options based on the percentage ownership the recipient will get. For instance, senior executives can be granted 1% of the company while lower-level managers get smaller percentages. The percentage you get depends on the company’s valuation at the time and the ownership structure of the company. This method is normally used for top executives and management staff.
A more common method of allocating pre-IPO stock options is to decide on a fixed number of stock options to be given to each eligible party. The allocation per individual can be broken down to cater to other factors such as tenure, performance, job level, etc. For example, a top-performing department head could get 20,000 stock options while a new sales associate gets 5000 pre-IPO stock options.
Some companies choose to use several factors such as job role, performance, or tenure to determine how much equity to cede but in an open-ended manner. For example, employees who have been with the company from the start (founding employees) get a large number of stock options allocated to them than those who joined midway.
It is very common for companies to come up with an allocation structure that is customized to their situation, valuations, goals, and other factors. For example, they may get a valuation done at the point of issuing the pre-IPO stock options to get an idea of how much the employees will need to pay to purchase the shares when they vest. It is one of the most common methods of allocation which is also part of the reason why pre-IPO stock options can be a bit opaque by nature.
In evaluating the weight of pre-IPO stock options offered to you, you need to do a deeper analysis of the stock option contract you have to sign to get them. For instance, what is the vesting schedule pegged and how achievable or fair is it? Also, you might find it necessary to compare what other companies of a similar size and profile of the issuer are offering and what other employees have been offered.
Please note that some pre-IPO stock option packages are complicated either by design or by accident. It is, therefore, advisable to seek expert advice before you exercise them. In some circumstances, you might yourself staring at a tax bill after exercising your options that you hadn’t planned for.
Similarly, those being offered pre-IPO options as part of the recruitment process should gauge them before making a decision. Key questions to ask if you find yourself in this situation include, the terms and conditions attached to the options offered, the value of the company, and what other companies are offering.
There are many advantages or benefits that come to those who possess pre-IPO stock options. These benefits apply across the board and for all types of options. Here are some of them:
Imagine the early employees and lucky people who had a chance to purchase pre-IPO stocks from top-performing companies like Apple Inc, Google (Alphabet), Microsoft, Tesla, etc. Most of them are probably billionaires now and even those who sold their shares after the IPO reaped big. These cases highlight the beauty of holding pre-IPO stock options that you can later convert to real equity.
For most people, the potential financial upside of owning pre-IPO stock options is irresistible especially if it is a company they believe in and play an active role in its success. The whole idea behind pre-IPO stock options is to give a special group of people a chance to reap the company’s success. This is why pre-IPO stock options are granted at a discounted rate so that they appreciate.
While it is not guaranteed that the value of pre-IPO shares will increase, the expectation is the company will continue growing and a liquidation event will increase its value exponentially. Employees who are usually the principal targets for pre-IPO stock options also have a chance to ensure the company succeeds. They can do this by hitting their performance goals and doing everything in their power to make the business a success.
After a liquidation event, you can sell your pre-IPO stocks and take home a huge payday for your troubles. In most cases, however, holders of pre-IPO stock options tend to liquidate a small portion after the IPO and hold the rest if they believe in the company’s future. Some companies also restrict the amount of pre-IPO shares you can sell immediately after an IPO to protect the company’s value in the open market.
Ultimately the allocation of pre-IPO stock options is a great way for a company to ensure the interests of its employees are aligned with its own. Employees and other close stakeholders who own stock options are not only motivated to perform but they are more likely to stick with the company for the long term. The alignment of interests is great for the success of the company especially when it nears an IPO event.
The following are some of the risks and things you need to consider when buying or exercising your pre-IPO stock options:
As stated elsewhere in this post, most companies have strict limitations on the transfer of pre-IPO stock options or shares. This means you cannot easily liquidate them if you need the money or when you leave the company before a liquidity event like an IPO occurs. In some, some companies do allow the buying and selling of pre-IPO equity in secondary markets but this practice is not very common.
By nature, pre-IPO company valuations can be shaky and uncertain which increases the risk of pre-IPO stock options. Should the company’s IPO underperform, you also run the risk of owning pre-IPO shares that are not worth what you hoped for upon purchase. To avoid this, ensure you get expert help to determine the fair value of the company before exercising the vested options.
As mentioned throughout the post, there are various tax implications associated with pre-IPO stock options. Taxes usually come into play when you exercise the stock options or sell them in the open market. For example, NQSOs are treated as ordinary income upon being exercised in the USA and therefore subject to withholding income tax. Make sure you are comfortable with the taxes you will need to pay upon owning these pre-IPO stocks before you exercise them.
To get the best value from pre-IPO stock options, you need to know a few things, starting with the valuation of the issuing entity. Here are some of the critical pointers to help you when making such decisions:
Understanding a company’s potential will help decide if it is worth exercising your pre-IPO stock options. It involves researching the company’s fundamentals, growth prospects, and market position and can be done in the following ways:
Companies intending to go public are required to file the S-1 with the Securities and Exchange Commission (SEC). The S-1 and prospectus can provide valuable insights into a company’s risk factors, growth strategies, and operations. This information is important for anyone trying to gauge a company’s potential before exercising the pre-IPO options.
If possible, also look into the company’s financial health by perusing available income statements, cash flow, and balance sheets. Private companies tend to hold on to their financials but are likely to disclose them if they intend to go public. Also, look at the company’s funding history to gauge investor sentiment and appetite for the company’s equity pre-IPO.
Look for documents outlining the company’s management team and practices and track record as part of your analysis. Such information will help you determine if the company has the potential to excel which in turn informs your investment decision. Look for information on key management individuals and see if they have notable accomplishments and a history of successful leadership. ]
Which industry does the company operate in and what does competition look like? Do the company’s products or services match industry trends? Do they have a sustainable competitive advantage that will guarantee their growth and success in the long term? Understanding a company’s positioning in the industry is key to unraveling its future potential before investing pre-IPO.
Market research differs from an industry analysis as it focuses on the customers and target market. You can find information from secondary and primary sources such as news articles, blog posts, customer reviews, testimonials, and social media metrics. This information will help you determine if the business has a viable product or service and if it has favorable market positioning.
Analysts often generate insightful reports about pre-IPO companies that can be used to assess a company’s potential. You can find these reports on news sources, investment journals, company publications, and online. Pay close attention to what these external parties are saying about a company’s IPO impending IPO event to judge if your pre-IPO shares will appreciate when it happens.
Exercising your pre-IPO stock options involves purchasing the number of allocated shares as per the contract you signed at the exercise price granted when you got them. You can only purchase the shares when there are vested as outlined in the vesting schedule. By buying the pre-IPO shares, you become a shareholder of the company but it doesn’t necessarily give you voting rights.
To exercise your pre-IPO stock options, you need to avail the necessary funds to cover the cost of the shares you were allocated at the strike price. The current value of the underlying shares does not come into play which can be advantageous if the company value is appreciated.
Don’t just exercise your pre-IPO stock options because you feel obligated to or because they have vested. Here are some important things to consider first:
Consider the company’s current valuation which determines the current value of its shares before exercising your stock options. A valuation can be done independently or by looking at the most recent estimate of the company’s value. You can choose to forfeit or postpone the exercise rights if the current price is lower than the strike price and the vesting period is still active.
The decision to exercise stock options is also determined by your financial goals. For instance, you may want to hold on to the options until they appreciate to a certain level before selling them in the secondary market if allowed. Just make sure your goals are aligned with the nature and performance of the pre-IPO stock options.
Exercising some pre-IPO stock options open you up to new taxes on your income or capital gains. You may want to wait until certain conditions are met to avoid paying too much in taxes are AMTs. It is advisable to seek the services of a tax expert when determining the amount and type of taxes due for pre-IPO stock options at the time of exercising.
You have exercised your pre-IPO stock options and now have possession of real company shares; congratulations! Now, how do you go about building wealth or cashing in on the shares? There are two main ways you can utilize your pre-IPO shares. They include:
Secondary markets do exist where you can trade your pre-IPO shared for cash. However, many companies have strict limitations on the exchange of pre-IPO shares in secondary markets. Should you sell in these markets, you get the price per share close to the company’s current estimated value but more likely influenced by free market forces of supply and demand.
A majority of pre-IPO shareholders wait until the company goes public so they can offload their shares at the market price. Even then, most only sell a small percentage of their allocation and choose to hold them for the long term as long as they work with the company or are affiliated. The price you sell your pre-IPO shares at is determined by the performance of the IPO event and market forces.
In not-so-common circumstances, companies issuing pre-IPO stock options may choose to buy back the shares from the holders. Various conditions could necessitate this action which are beyond the scope of this post. This option allows you to offload your shares pre-IPO and cash in but you will have to pay capital gains tax on the amount you receive.
Another instance where you can sell pre-IPO shares is if the issuing company goes through a non-IPO liquidity event like a merger or acquisition. In such cases, you will surrender your equity to the acquiring party or back to the company in exchange for cash minus taxes due. The shares will still be bought at the current fair value of the issuing company per unit.
One vital undertaking you must take when dealing with pre-IPO stock options is tax. All types of pre-IPO stock options are subject to different taxes mostly at the point of exercising or at the point of selling. It is, therefore, important to do some tax planning, ideally with a tax expert to help you with the complexities of pre-IPO taxes.
Tax planning for pre-IPO stocks helps you get above your tax liabilities, optimize tax treatment, manage your cash flow, understand Alternative Minimum Tax, and to comply with reporting requirements. For instance, you need to know the implications of the bargain element when it comes to exercising as it affects the amount of ordinary income tax you pay.
Some strategies to consider using when planning for pre-IPO stock options include the following:
Qualified Small Business Stock (QSBS) is the stock issued by certain eligible small businesses that qualify for favorable tax treatment. Under the current U.S. tax law, if the requirements are met, you may be eligible for an exclusion that can be 100% of the capital gains realized from the sale of QSBS.
To qualify for the QSBS treatment, the pre-IPO stock must be issued by a qualified small business, held for a set holding period, and must meet other criteria outlined in the relevant tax code. Please note that the availability and rules around QSBS treatment vary. We recommend consulting with a tax professional who will assess your eligibility and help you maximize tax benefits.
The 10b5-1 plan is a pre-arranged trading plan that allows you to liquidate a predetermined number of shares at predetermined times or based on predetermined criteria. You can establish a 10b5-1 plan to benefit from certain tax advantages and avoid potential insider trading allegations.
Pre-IPO stock options have been used to incentivize, reward, and retain employees with marked success in the past. In many of the success stories, holders of exercised pre-IPO stock options reaped big when the issuing companies went public or were acquired. There are probably thousands, if not millions, of these success stories all over the world but we will highlight these two recent cases:
The famous data analytics startup known as Palantir (PLTR) is a shining example of a company that had a successful pre-IPO stock options strategy. Palantir notably used pre-IPO stock options to not only reward and incentivize existing employees but to entice top talent from the industry.
The reported pre-IPO price was $7.25. When Palantir went public in late 2022, there was strong demand for new technology stocks and its stock opened trading at $10. The value of issued pre-IPO stock options grew substantially and the company has maintained growth to date.
The food delivery platform DoorDash had a generous pre-IPO stock options program for its employees throughout its early years. When they went public in December 2020, DoorDash’s stock rose 86 percent past its initial public offering price of $102 to close the day at $189.51. This provided substantial returns for employees who held pre-IPO stock options.
So many companies nowadays offer different types of pre-IPO stock options to employees as a means of rewarding them, winning their loyalty, and as an alternative means of compensation. At the same time, outsiders can take advantage of the secondary markets to get their hands on these potentially lucrative pre-IPO shares. With good strategy and planning, you can reap big from these financial instruments but you need to be keen and seek professional advice when needed. All the best and happy investing!