The IPO or direct listing of a company you’ve been a part of is an exciting event that is the culmination of years of triumphs, setbacks, growing pains, and uncertainty. The elusive promise of liquidity is finally coming to fruition, but that doesn’t mean the benefits of concentrated equity planning are over. Balancing tax optimization with achieving your financial objectives will impact your decision-making and require consideration of the types of equity compensation you received, how long you’ve owned certain shares, unexercised options, the possibility of tax exemption with QSBS, and more.
With your company now public, you’ll be able to see intraday fluctuations in the stock price; it’s a stark contrast to infrequent 409a valuation updates and preferred stock capital raises. Compounded by the relatively high volatility and cyclicality of newly public tech companies, these price fluctuations can give rise to behavioral biases, potentially leading to impulse decisions and suboptimal execution of a divestment strategy. Emotions will inevitably come into play – acting on pure objectivity isn’t the goal, but understanding and being able to manage human nature will ensure you’re making decisions that don’t inadvertently jeopardize your goals.
Whether you’re currently at your newly public company or left before the IPO, there are many things to consider when creating a divestment plan. From the percentage of your net worth the concentrated stock makes up to the breakdown of individual tax lots, every facet can change the strategy that ultimately makes the most sense for you. Here are the big questions you should think about.
How much of your net worth does your concentrated stock make up?
A holding is generally considered concentrated if it exceeds 10% of your investment portfolio. For startup employees, it’s not uncommon for their company’s stock to become over 50% of their investment portfolio. With such high levels of concentration, once liquidity is available, a divestment strategy is critical to begin lowering concentration risk. Even though your company has experienced fantastic growth over the years, a continuation of that growth is never guaranteed.
Your company’s IPO can be a financially transformative event that allows you to make huge changes in your life with your newly liquid wealth – converting illiquid “paper wealth” into something that can springboard you towards achieving your financial goals. Reducing your concentrated position might not mean simply diversifying your investment portfolio. You might want to buy a house, a new car, set aside money for vacations, or even use some of the proceeds for a new business venture. Many of these aren’t part of an investment portfolio, but they’re still important components of a comprehensive financial plan. Because of this, we prefer to consider these concentrated holdings as a percentage of net worth or overall assets rather than within the context of the investment portfolio alone.
What are your objectives for your stock?
Once you’ve figured out how much of your net worth your concentrated position makes up, what do you want to do with it? How much do you want to allocate to staying invested in the markets, making big purchases, business investments, retaining your company’s stock, etc.? Will the split between investment assets, personal assets, and increased annual expenses keep you on track to meet your long-term goals?
Risk tolerance is something else to think about when defining objectives. It’s true that the success of your company has resulted in a huge payoff so far, but to what extent would you be willing to risk losing that money again? Remember that future growth and success mimicking the past isn’t guaranteed. Public companies fail too. Sometimes it comes down to being at the wrong place at the wrong time – an economic downturn can derail a company whose market price is largely dependent on hitting growth targets and managing leverage. Or maybe the introduction of public scrutiny and answering to shareholders quarterly hinders the long-term outlook was easier as a private company. At the end of the day, having a concentrated position is risky, and determining and allocating to your risk tolerance will reduce the chance of a loss of value exceeding your tolerance.
Determine the breakdown of your holdings.
Stock acquired in different ways is taxed differently, and the timing and cost basis of your stock acquisitions also change your tax liability at the time of sale. For current employees, unexercised options, participation in an ESPP, and ongoing option or RSU vesting are added complexities. Knowing how your current and future ownership is broken down will help you avoid minor tax inefficiencies to large blunders. For example, a disqualifying disposition of ISOs when you have NSOs eliminates any potential tax benefit you could have received from holding the shares from ISOs until they become qualified. Unfortunately, treating different grants or tax lots as equivalent to another is something that happens often, sometimes with disastrous results.
Determine if any of the stock you hold is qualified small business stock (QSBS) or close to the five-year holding requirement (if you meet all other requirements for QSBS). Selling QSBS can result in up to 100% of your capital gains from being tax-free, a huge benefit.
Knowing what you have now and when tax lots will gain long-term capital gains or QSBS status will allow you to optimize your divestment strategy while staying on track to achieve your objectives.
The plan you create could span multiple years and require adjustments over time.
Market values change over time, your company could do better or worse than expected, and your goals might change too. The goal of an initial plan is to build a strategy that takes into account each tax lot to strive for tax efficiency, achieve your objectives, and take unexpected events in stride by incorporating uncertainty.
Don’t work through the decision-making process in a vacuum. The focus of your divestment plan is your concentrated holding, but option or equity ownership in other companies or expected changes to your overall tax or financial situation are a couple of factors that will create additional complexity.
A strong company doesn’t necessarily mean strong performance in the markets.
How promising or solid your company is – whether objectively or subjectively – doesn’t inform its performance in the stock market. A myriad of factors come into play with price performance, from global market sentiment to a seemingly innocuous comment made in a quarterly earnings report. Perhaps most important is the fact that people ultimately control the markets, which introduces subjectivity, behavioral biases, and the possibility for human error. Even algorithmic trading and quant strategies are susceptible; after all, someone created the rules for the strategy to follow.
It’s important to recognize the difference between a company and its stock. Selling doesn’t have to mean you don’t believe in the company anymore. You might feel the stock is overvalued because of investor enthusiasm or just no longer has a place in your portfolio at such a high concentration.
Current employees may face restrictions that make it harder to execute a divestment strategy.
To prevent violations of insider trading laws, publicly traded companies restrict the trading activity of those who might have access to material non-public information. These include trading windows, specific timing restrictions on certain individuals, a mandatory structured-selling plan (a 10b5-1 plan), and limitations on using hedging instruments like call and put options. Trading restrictions will inform the timing of trades, and in the case of an inability to use hedging instruments, could change the overarching strategy as well.
A 10b5-1 plan is easy to set-and-forget, but if your company doesn’t require you to have one, you might want to think twice before executing one.
Certain high-level people at a company will be forced to set up a 10b5-1 plan in order to buy and sell their company’s stock, but sometimes the option is open to other employees and executives as well. With a 10b5-1 plan, an insider creates a trading plan (usually for the next year) which gets executed automatically. If / then rules can be put into place in an attempt to take into account unexpected price changes (eg. Sell 1,000 shares each month, but if the price on a trade date is above $50, sell an additional 1,000 shares.), but the plan won’t be able to address every possibility. Therefore, we typically hesitate to recommend a 10b5-1 plan if your company doesn’t require you to have one. Structured selling during open trading windows offers a higher degree of flexibility, and the ability to make changes to decision-making during the year. However, there are situations where a 10b5-1 plan could make more sense for you.
If you’re worried about sticking to your plan, a 10b5-1 plan will force adherence.
Whether your company’s stock performs better or worse than you expect, it’s easy to fall into behavioral traps when the price doesn’t fall within expectations. Your company’s stock price will fluctuate over time, sometimes acting unexpectedly as your company navigates the public market, economic, and geopolitical landscapes. Everybody is different, and behavioral traps affect all of us to some extent. Some are pushed to sell more if performance is subpar, others want to hold on until the price climbs back to meet expectations. When performance exceeds expectations, a fear of missing out of continued success will cause some to hold even when imprudent, and a fear of losing those embedded gains might urge some to take all the gains and move on.
A 10b5-1 plan will force adherence to whatever plan you put into place because they are effectively irrevocable once established. While modifications can technically be made, they call into question your good faith to avoid insider trading and may result in plan termination. Many companies won’t allow any modifications as a result. If you’re worried about emotions getting in the way when the time to make trades comes, a 10b5-1 plan will enforce the trades you decided on when you were planning objectively and prevent holding on too long or selling too fast and early.
Former employees generally have fewer moving parts to complicate their divestment strategy, but more available strategies.
Once you leave and vesting stops, no new grants are awarded, and ESPP participation ends, the stock you’ve accumulated is what you have to work with. Determining how much to sell from each grant and tax lot becomes a lot simpler since there’s no new equity to complicate things. Of course, hopefully your new company provides equity compensation as well, but outside equity is considered in a different way.
Leaving also gives you the benefit of no longer being considered an insider. Blackout periods are lifted, there’s no need for a 10b5-1 plan to prevent insider trading, and more hedging strategies become available. A divestment strategy for former employees can be as simple as selling a certain number of shares over time or incorporating other strategies designed to reduce downside risk.
A few hedging strategies include buying and selling options, using a variable prepaid forward contract, or participating in an exchange fund. Whichever strategies you choose, consulting a CPA is necessary, and we also highly recommend consulting a financial advisor.
Options can be bought and sold with your specific company as the underlying, but new public companies often don’t have the option volume to support large hedging trades. Other securities can be used as proxies, like the S&P 500 or a tech sector ETF, but using a proxy introduces the risk of the correlation between your stock and the proxy falling and your hedge failing.
Buying put options below the current price offers downside protection at a cost (like paying for insurance), while selling call options higher than the current price caps your upside in exchange for receipt of some income (the premium). The combination of buying a put and selling a call is an options collar, creating a known range between maximum loss and maximum profit.
Structuring an options collar isn’t as simple as buying puts and selling calls using your stock as the underlying. Volatility of the underlying, pricing of the options themselves, options strike prices, time until expiration, and many more factors need to be taken into account in order to have a solid strategy. It’s possible to do it yourself, but be aware of opening yourself up to unforeseen risks.
Variable Prepaid Forward Contract
A variable prepaid forward contract is a divestment strategy established with another party, usually an investment company or investment bank. Typical minimum notional amounts for a variable prepaid forward contract are around $5M. With a variable prepaid forward contract, you receive cash today (this can be 10%-25% lower than the current value of your stock) in exchange for a predetermined number of shares (or the equivalent value in cash) at different terminal price breakpoints. If the stock performs poorly, you walk away with the cash received up front but no shares. If the stock performs well, you walk away with the cash received up front, and a variable number of shares based on the performance (up to a cap). The contract length is typically three to five years.
The investment company buys and sells options using your company’s stock as the underlying, often a complex set of options collars and similar strategies. They’re betting on their investment strategy and the shares they receive at the close of the contract to make up for the up-front cash outlay and generate a profit.
It seems like a similar result can be achieved by selling a substantial percentage of your holdings today and capturing any remaining upside in three to five years. So if you only receive 75%-90% of the current value of your shares and could do something that feels similar while retaining flexibility, what’s the benefit of a variable prepaid forward? Taxes. When structured properly, variable prepaid forward contracts are taxed at the termination of the contract, even though you received cash today.
The specifics of variable prepaid forwards are beyond the scope of this paper, but if you decide to explore them for your divestment strategy, be very careful with the contract execution and any modifications made. The U.S. Court of Appeals Second Circuit ruled that certain modifications to a contract constitute a taxable event, overturning a Tax Court decision on the same case. Additionally, if your variable prepaid forward isn’t structured correctly to begin with, the up-front cash payment might be considered a taxable event, eliminating the tax benefit.
Exchange funds achieve diversification by pooling the concentrated holdings of many investors. Unlike selling your concentrated stock and purchasing a diversified basket, participating in an exchange fund doesn’t constitute a sale – so capital gains taxes are deferred. Instead, contributions of concentrated stock are considered non-taxable partnership contributions.
Exchange funds are more nebulous than the other strategies discussed here. Each fund has professional managers who, among other things, determine which concentrated positions will be accepted into the fund to achieve a target diversification level and asset allocation. You might not get the level of diversification you were hoping for or could remain exposed to the same risk factors as your original concentrated position – both could render the exchange fund ineffective.
Requirements for most exchange funds include “qualified purchaser” status ($5 million in investable assets), a minimum of $1 million contribution of concentrated stock or more, and a seven-year lock-up period to meet the requirements for tax deferral. Additionally, at least 20% of an exchange fund must be invested in illiquid assets (typically real estate), so the fund will either use leverage or require investors to contribute additional cash to meet that requirement.
One of the biggest benefits of an exchange fund is that at distribution, you receive a basket of shares, not cash. Whether it’s a pro-rata distribution of all holdings in the fund or some subset of the holdings (each fund has its own distribution rules), the distribution is also non-taxable. Capital gains taxes will be due only when the individual securities are sold, so this essentially trades your concentrated holding for a more-diversified basket tax-free.
Every exchange fund is different, so if you decide to look into them further, gaining a full understanding of the specifics of the funds you’re exploring is critical.
Your company’s IPO can have a big impact on your financial future, so it’s important to prepare for it as your liquidity window approaches. The final price when you sell may be unknown now, but proper planning will allow you to take that uncertainty in stride. Coordination with your advisors and CPA is crucial to avoid tax and strategy missteps. If you’re getting ready to plan for an upcoming liquidity event, we’d be happy to discuss your concentrated position and divestment strategy with you – feel free to send us an email.
Important Information: The information and opinions herein are for informational use only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice, nor do they constitute tax or legal advice. ClearPath does not guarantee the accuracy or completeness, nor does it assume any liability for any loss that may result from the reliance by any person on any such information or opinions. Information and opinions are subject to change without notice. No assurance can be given that any forecast or target can be achieved. Forecasts are based on assumptions, estimates, opinions, and hypothetical models which may prove to be incorrect. Past performance is not indicative of future returns and does not guarantee future results. Research obtained by unaffiliated 3rd party sources are deemed reliable by ClearPath, however, ClearPath does not guarantee accuracy or completeness, and makes no warranties with respect to this data. ClearPath Capital Partners is not a tax advisor, and does not provide tax or legal advice. Consult your tax or legal advisors with regard to your personal tax situation, and before implementing any tax or legal strategies.