Many private companies offer equity compensation in the form of employee stock options. For employers, offering this benefit is one way to attract and retain talent.
Equity compensation can create a shared interest in the company’s overall success. If the company does well and the stock price appreciates, employees who hold company shares can increase their own wealth by exercising and selling valuable stock.
But when you work for a private company, employee stock options you get through equity compensation plans may come with a few strings attached that you may not need to worry about if you work for a public company. The biggest is that you may not be able to sell the company stock you hold.
Often, it’s only if the company goes public that you may get the chance to sell your stock. If you’re lucky enough to work for a company that goes from private to public, equity compensation could be a great way to increase your own wealth – but that’s a big “if.” Other times, some private companies may offer a secondary market that can facilitate a sale, but there may be restrictions on that too.
The limitation on selling stock can add an additional complication when you consider how the potential value of equity fits into your financial plan. This limitation can also impact the way you strategize on exercising shares, paying taxes, and addressing the risk of owning something you might not be able to sell.
So, if you have private stock, should you wait until the stock goes public and address the issues then? Or do you plan now, maybe exercise and hold some of your shares, and hope that you put yourself in a better position later?
Let’s review some of the things you should understand in order to make a plan for what to do with your equity compensation when you work for a private company:
1 – Understand the Basics of What You Have Been Awarded
Whether your company is publicly traded or privately held, you should review your equity compensation package and fully understand the details before trying to make any plans or decisions.
Here are a few key points that you’ll want to consider as you review your company’s plan document, which should detail what you need to know about your equity compensation:
- The type of option you’ve been granted: Do you have incentive stock options or non-qualified stock options?
- The strike price: This is the price you pay to buy shares of stock if you exercise your options.
- The vesting schedule: Generally speaking, this represents the time between when your award is granted and when you can rightfully take ownership of the shares.
- The expiration date: Options aren’t good forever. The expiration date is the last day that you can exercise your stock option.
- The current value (bargain element): The difference between the strike price and the current stock price is the bargain element per share. This value helps determine how much the shares are potentially worth, and what the tax implications of an exercise may be.
Knowing these specific details for your options may give you the information you need to make informed decisions about what to do with your equity compensation.
2 – A Low Strike Price Might Mean a Low Cost to Exercise – But That’s Not the Only Thing to Consider
Stock options at private companies are often issued with a low strike price. This allows you a chance to buy shares for a low cost, which requires less cash up front.
This is a good thing when you consider how your cash flow will be impacted by an exercise – but this is only one thing to consider.
You should also evaluate the cash you may need to pay a potential tax liability if you exercise and hold your options. Exercising stock options is a reportable taxable event regardless of whether or not your company is private or public.
You’ll want to know how much cash you may need to purchase shares and to cover the tax bill if you exercise and hold your shares. Once you know the total amount you need to do both, you can better determine whether or not it’s a good idea to exercise.
3 – You May Buy Something That You Cannot Sell
Before you exercise private company stock, you’ll want to know whether or not you can sell your shares.
One benefit of a publicly-traded stock is that if you want to sell your shares, you can likely do so on a public exchange. You may need to confirm you’re in an open trading window before doing so or aren’t otherwise restricted, but generally speaking, it’s easy to sell shares of public companies.
Some private companies will allow you to sell shares in a secondary market, which gives you a chance to sell shares you own after exercising. However, not all private companies offer this luxury. Even if your company allows for the sale of shares in a secondary market, they may have other restrictions in place that you must adhere to as well, such as a right of first refusal.
If your company is private and has no secondary market where you can sell your shares, you should consider how this will impact your willingness to exercise your options. It’s possible to find yourself with options you exercised and shares you paid for… and no way to make that money back through selling those shares.
4 – The Tax Rules Don’t Distinguish Between Equity Compensation from Public and Private Companies
When you exercise stock options, it is a taxable event. How you report the taxable event and how much tax you pay depends on several factors, like whether or not you have incentive stock options or non-qualified stock options.
If we assume that you have incentive stock options, the tax rules state that if you exercise and hold the shares past calendar year-end, the bargain element is a reportable event for calculating the alternative minimum tax. If you owe the alternative minimum tax, you’ll need to find a way to pay for it.
Non-qualified stock options, on the other hand, may be taxed as ordinary income when you exercise. But no matter what kind of options you have, exercising them may cause you to pay taxes — regardless of whether the company is public or private.
5 – Even with Limited Ability to Sell Your Shares and a Pending Tax Bill, Exercising Might Still Make Sense
There can be considerable risk associated with exercising private company stock and the cash call necessary to exercise and hold shares. Other things like a pending tax liability and uncertainty around how to “get out” are reasons to evaluate how exercising private stock options fit into your financial plan.
But while the risk is real, there may be some advantages to exercising your private company stock, too.
One potential advantage of exercising private stock is that the AMT impact may be lower now than it may otherwise be in the future. A key factor in determining how much AMT you owe from an exercise of incentive stock options is the spread between the fair market value at exercise and the strike price.
If we assume that the spread between the two is smaller now than it will be later, the AMT you may need to pay will likely be smaller, too. The net result of this may mean that you can exercise and incentive stock options now with a lesser tax impact than you will have in the future.
Exercising sooner rather than later may also be beneficial when you want to sell your shares. You could not only secure a lower bargain element when you exercise and hold, but you also begin the holding period requirements for a qualifying disposition.
This means that you can sell your shares sooner rather than later (assuming there is a market to sell) and still obtain long term capital gains treatment.
6 – If the Company Does Go Public, You Might Need to Wait Even Longer to Sell Your Shares
Sometimes, a private company goes public through an IPO, or an initial public offering. The process of going public takes private company stock and turns it into a publicly-traded stock that trades on an exchange.
A key benefit for stockholders in this situation is access to a publicly-traded market where you may more readily sell your shares. However, going public does not always mean that you will be able to sell your shares right away.
Many times, companies that IPO place restrictions on your ability to sell your shares for 6 months after the offering. You may also be restricted by your status in the company, your ties to a 10b5-1 plan, or lock-up periods set by your company.
While an IPO might make your shares more liquid than they otherwise were as a private company, your ability to sell may still be restricted to certain times and by certain rules.
7 – There Might Be Other Liquidity Events Besides an IPO
When we talk about liquidity events for private companies, we usually talk about IPOs – but it is possible that your company experiences something very different. Your liquidity event might be a merger, acquisition, or takeover that could impact your stock compensation.
If another company acquires yours, for example, your stock options might be converted to stock options of the new company. You could then cash those out if you chose to do so. But this is just one example; there are many ways equity compensation could be impacted by something like a merger or acquisition.
Some of these decisions might be out of your control, while others might give you more choice about the route you take with the equity comp you bring forward from your previously-private employer. The specific details will likely be part of the agreements between the buyer and the seller.
What to Do Next with Your Equity Comp When You Work at a Private Company
When you work for a private company, you may want to take additional time deciding whether or not you should exercise your shares. Not only may you need to address the pending cash flow needs, but you’ll also want to address the risk associated with buying a stock that you may not be able to sell.
Don’t forget to consider how private stock fits into a big-picture financial plan, too. An illiquid stock, even one with the potential of future wealth, likely adds additional complications to a financial plan. That’s not necessarily a dealbreaker, but it’s something that you should factor into long-term planning.
Going through this process of evaluation and planning can help determine what your best course of action may be. It can also provide insight on how to plan well for your private company stock moving forward.
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