This one is for the stock-compensated: employees and founders whose financial lives have become increasingly tied to the value of the company they work for.
For years, the value of your equity may have been mostly theoretical. Now, suddenly, you can start putting real numbers around it. That can be exciting. It can also create a new kind of pressure: How do I make the most of this without making a mistake I’ll regret?
Earlier this year we shared Seven Smart Moves for Stock Compensation based on our experience working with many professionals navigating this complex topic. This time, we want to focus on three things that may need recalibration as your IPO nears:
- What should this wealth change about your goals?
- Are you managing taxes strategically?
- Are you taking the right amount of investment risk?
Wealth planning is an exercise in projecting how a pool of assets today can support a lifestyle for a lifetime. With a highly appreciated, concentrated stock position, taxes and investment risk become two of the most important variables to rein in as you plan for the long term.
Calibrate your goals
When you think about the wealth tied up in your soon-to-IPO company, are you dreaming too big or not big enough?
With pre-IPO stock, it’s tempting to start counting chickens before they hatch while all the eggs are still in the same basket.
There’s no shortage of ideas we’ve seen people have about what to spend the money on – their dream home, nicer cars, luxurious travel, private school, collectibles, clubs, or even private aviation.
Others aren’t so eager to satisfy champagne tastes; they simply want to worry less, spend more freely, help loved ones, or maintain the same lifestyle while working less or retiring earlier.
Some will want to start supporting their favorite charities in a meaningful way. After all, as we’ve written before, your company’s highly appreciated stock may be the single most tax-efficient asset you’ll ever have to give to charity. If you have any inclination for philanthropy, the IPO might be the best moment to start figuring that out.
The common thread through all these potential desires is the need to sharpen the pencil – and wait out the uncertainty – before committing to anything.
We’ve all seen how IPOs can seem imminent but get delayed months or years. Initial share price estimates may or may not pan out. Anything can happen to the stock price in those first six months of trading between the IPO and when the lock-up period ends. It’s important not to anchor your expectations to the wildest success stories you see in the news or on social media.
Calibrate your tax strategy
Individual circumstances will vary widely in how much after-tax wealth will be available when it’s time to start spending.
For example, if the majority of your shares are tied to Incentive Stock Options (ISOs), you may get the more favorable long-term capital gains tax treatment all the way down to an ultra-low strike price set years ago – but only if you stay invested in the stock for a full year after exercising them. At the highest federal rates, we’re talking about a difference of 23.8% in capital gains tax versus 37% in ordinary income tax, or over $130,000 per $1 million in tax liability.
Others may have double-trigger vesting RSUs, which fully vest at the IPO, and will be considered an ordinary income tax liability all at once – maybe all in the highest tax bracket. After paying federal and state taxes, you may be left with half of the headline number.
And this is before we even consider any other details. How much are you and your spouse earning? What else affects your tax bracket? How much cash or other investments do you have? Are you planning a charitable contribution of low-basis shares?
Whatever the case, proactive planning can sometimes reduce the tax burden, spread it out over years (potentially in lower brackets), or – using tax-loss harvesting investment techniques like direct indexing – shift the burden to a more diversified portfolio that can be more comfortably held for the long term.
Calibrate your investment risk
There are two reasons you may want to continue holding your company’s stock after your lock-up period ends.
- You want to hit the one-year mark for favorable tax treatment of your ISOs, or otherwise delay the payment of taxes on a sale.
- You still believe in the company’s further upside.
Either reason could be rational, emotionally biased, or a little of both. We’ve seen clients range from derisking immediately to holding uncomfortably large exposures for years.
You may be able to mitigate the risks in the first case, and there’s room for compromise on the second.
In delaying a sale for tax reasons, there are techniques you can employ to de-risk while you wait to meet an ISO holding period or a lower income year to harvest gains in a lower bracket. For example, a “zero cost collar” uses call and put options to keep the stock’s value within a relatively narrow range while you wait.
More challenging is separating legitimate conviction from behavioral bias. Endowment bias is the preference for assets you already own. Recency bias is a belief that the recent past (i.e. your company’s meteoric rise) will continue. Familiarity bias is having a more favorable opinion of companies you know than companies you don’t.
All of these biases tend to make newly-minted stock-compensated moguls a little too willing to sit in the concentrated risk of their company for longer than we believe is prudent.
On the one hand, if you remain an influential player after the IPO, you may reasonably believe your work can affect the company’s future success – or that public markets underappreciate what you see happening internally.
On the other hand, “the market” might be smarter than you think. Publicly traded stock markets are littered with examples of once hot companies whose share prices fall and languish post-IPO, never recovering to their all-time highs. We tend to underweight those failures because success stories are more visible. One study by BlackRock and MSCI found that 42% of companies in the Russell 3000 index since 1987 fell by 50% or more and never recovered.
Given that risk, we often look for a middle ground that respects optimism while limiting the worst-case scenario – perhaps cutting exposure initially, then diversifying systematically over months or years. That also makes long-term planning more reliable: it is difficult to assign a sensible expected return to one stock, while a diversified portfolio gives us a much more defensible basis for projecting how assets can support lifelong goals.
Diversification may cap upside scenarios in the retirement forecast, but it almost certainly shores up the downside relative to concentration in a single stock.
Calibrate before you celebrate
An IPO can change your financial life very quickly. Your relationship with money may take longer to catch up.
The goal is not to squeeze every last dollar of upside out of your company stock, minimize every dollar of tax, or immediately upgrade every part of your lifestyle. It is to understand what this new wealth can reasonably support, what risks are still worth taking, and which taxes are worth paying to turn a volatile concentration into something more durable.
Goals, taxes, and investment risk all have to be considered together.
There may be no single perfect moment to sell, diversify, spend, give, or walk away from work. There will almost certainly be tradeoffs. But the better you understand those tradeoffs before the stakes become highest, the less likely you are to make a decision you’ll later regret.
If your company is approaching an IPO, this is the moment to begin turning a potentially life-changing number on a screen into a plan for what you want the rest of your financial life to look like.
This article was guest written by Adrian Colarusso, a financial advisor with Target Rock Wealth Management and a participating advisor on the Willow platform. The content is provided for educational and informational purposes only and is not intended as personalized investment, tax, or legal advice. Individual financial circumstances vary, and financial planning strategies should be evaluated based on each person’s needs and objectives. Investing in initial public offerings (IPOs) involves significant risks, including market volatility, uncertain valuations, and the potential for loss of principal. Past performance of IPO investments is not indicative of future results. Advisory services offered through Willow Partner Advisors, LLC, an SEC-registered investment adviser.
