The myStockOptions Blog

Instacart IPO: Long-Awaited Liquidity For Employee RSUs And Stock Options

After hinting at an initial public offering (IPO) last year, delivery service Instacart has finally gone public with a listing on Nasdaq. It is the highest-profile venture-backed company to go public since the end of 2021. The IPO has been heralded as a sign of a potential resurgence in initial public offerings after a dearth in 2022 and the first half of 2023.

As with many later-stage startup companies, Instacart’s initial public offering (IPO) is as much about its human capital as its financial capital. Grants of restricted stock units (RSUs) and stock options are important forms of compensation for Instacart employees—but to cash in, they needed a liquidity event for the company’s stock.

That is why, in an interview with CNBC on IPO day, Instacart CEO Fidji Simo proclaimed: “This IPO is not about raising money for us. It’s really about making sure that our employees can have liquidity on stock that they worked very hard for.”

Filed under its formal corporate name Maplebear Inc., the company’s S-1 registration statement with the Securities and Exchange Commission (SEC) discloses details about Instacart’s equity programs for employees.

RSUs With Double-Trigger Vesting

Larger, later-stage pre-IPO companies often grant RSUs instead of stock options for many reasons, including concerns about shareholder dilution and high valuations leading to exercise prices that go underwater. Instacart is no exception. In its later stages before going public, the company moved in a big way from grants of stock options to grants of RSUs. No stock options were granted at Instacart in 2020, 2022, or the first six months of 2023.

The equity capitalization table from its S-1 shows the following total outstanding grants as of June 30, 2023, for its non-voting common stock:

Stock Options	29,910,133
RSUs	63,467,028

In a now common practice for later-stage pre-IPO companies, Instacart structured its RSU grants (and some of its stock options) with both the usual service-based vesting plus a second vesting condition that requires a liquidity event for the grant to fully vest:

1. With service-based vesting, you must work at the company for a specified period after grant. The service-based vesting period for these awards at Instacart typically runs four years, with a cliff vesting for part of the grant at one year of service followed by continued vesting monthly or quarterly.
2. With vesting based on a liquidity event, vesting conditions are met upon the earlier of (1) a change of control (e.g. a merger or acquisition) or (2) the effective date of a registration statement for an initial public offering of the company’s common stock.

Instacart also has some grants that vest only upon the satisfaction of both service-based vesting conditions and market-based vesting conditions (e.g. the achievement of specified future valuation or capitalization amounts). To make it even more of a puzzle to grasp all their different equity grants, the company made others that vest only upon the satisfaction of service-based, liquidity-event-based, and market-based vesting conditions.

Tax Hits For Employees

Many of Instacart’s employees have grants that met their vesting conditions immediately after the IPO. This will result in a big tax bill for employees when the shares are delivered. In fact, the value of the shares they receive will probably push most employees into the top tax bracket for all of their income in 2023—the one potential downside to the liquidity and wealth the IPO creates for them.

The S-1 registration statement explains that the company assumes a 47% tax-withholding rate for holders of its RSUs and shares of non-voting restricted stock that will vest and settle in connection with this offering. The company will automatically withhold shares from the RSU grants to pay the taxes owed, a practice referred to as “net settlement.” Instacart assumes a 43% tax-withholding rate for holders of its stock options, mostly via net option exercises.

$2.6 Billion Financial Impact

The use of stock compensation and the immediate non-cash accounting expense for the way the grants are designed to vest is so large that Instacart states the following in its registration statement (our bolding for emphasis):

“In the quarter in which this offering is completed, we will recognize approximately $2.6 billion of stock-based compensation expense associated with the satisfaction of the liquidity event-based vesting condition for outstanding RSUs and shares of outstanding restricted stock, for which the service-based and/or market-based vesting conditions have been fully or partially satisfied on or before August 15, 2023. As such, we expect to incur a net loss for the quarter and year in which this offering is completed, primarily as a result of recognition of this stock-based compensation amount.”

Amid dilution concerns, the company’s growing cash position enabled it to offer cash alternatives to employees. For example, the registration statement disclosed that in April 2023 it offered employees the choice to elect cash in lieu of a portion of certain equity awards.

Lockup Of Employee Shares With Potential For Earlier Sales

The liquidity for employees that Instacart’s CEO mentioned is not immediate. Instacart did separately register on SEC Form S-8, for employees’ public resale, all of the shares of common stock issuable under its previously granted equity incentive awards, along with those the company will grant in the future under its new equity incentive plan and separate employee stock purchase plan (ESPP).

Employees still will need to wait 180 days to sell their shares under the standard post-IPO lockup provisions. The S-1 registration statement reveals an exception that allows earlier sales during an open trading window should the stock trade at more than 120% of its IPO price for at least five of ten consecutive trading days. One of those days must occur after the company’s first quarterly earnings announcement.

Further Resources

Equity compensation is a key benefit for many employees at private companies, from startup to IPO or M&A stages. myStockOptions has articles, FAQs, videos, and quizzes that explain all aspects of private company stock compensation, from the basics to tax and financial planning.

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WEBINAR: 10b5-1 Trading Plans And Other SEC Rules Advisors Must Know

Thursday, October 12, 2023
2pm to 3:40pm ET (11am to 12:40pm PT)

Get crucial insights on the SEC's new rules for 10b5-1 plans and their impact, along with a solid grounding in other key SEC requirements, including Rule 144, Section 16, and insider trading.

Join us on Oct. 12 (2pm–3:40pm ET, 11am–12:40pm PT) for a webinar on the fundamentals and mechanics of Rule 10b5-1 trading plans, new SEC rules, evolving best practices, and most effective designs for executives, employees, and anyone else who wants to regularly sell stock to meet financial goals but knows material nonpublic information about the company.

Discover how to use these plans to maximize your clients' wealth in company shares, stock options, and restricted stock/RSUs while protecting them from insider-trading charges. The webinar's panel of experts will provide real-world case studies:

• Michael Andresino (JD), Partner, ArentFox Schiff LLP
• Rich Baker (MBA), Exec. Dir., Morgan Stanley Executive Financial Services
• Megan Gorman (JD), Founder, Chequers Financial Management
• moderator: Bruce Brumberg (JD), Editor-in-Chief and Co-Founder, myStockOptions

2.0 CE credits for CFP, CPWA, CIMA, CEP/ECA, EA (live webinar only), and CPE for CPAs (live webinar only); 1.5 potential self-determined CE credits for CFAs

Register now. Time/date conflict? No problem! All registrants get access to the webinar recording, which offers 2.0 CE credits for CFP, CPWA/CIMA, and CEP professionals, plus the webinar slide deck and handouts.

Stock Options In Private Companies: Deciding Whether And When To Exercise

Stock options in startups and other private companies can be very profitable. The stock may become highly valuable if the company goes public or is acquired. However, options in private companies are also risky, as the stock is illiquid until then and may be forfeited if the company fails.

Options in a private company, as with public companies, can be either nonqualified stock options (NQSOs) or incentive stock options (ISOs), though ISOs are more common for startups. In a potential twist, with private company options the terms of your grant may allow you to exercise them before they vest, including immediately at grant (sometimes referred to as early-exercise options). If you do this, you get restricted stock that has a vesting schedule identical to the options, and you make a Section 83(b) election with the IRS within 30 days of your exercise.

For all of these reasons, it's complicated. Some of the most common questions we get at myStockOptions.com involve whether and when to exercise private company stock options.

A recent myStockOptions webinar on stock option exercise strategies featured three leading advisors. Webinar panelist Megan Gorman, the founder of Chequers Financial Management in San Francisco (and also a Forbes.com senior contributor), discussed rules of thumb to go by when you have stock options in a private company.

1. Don’t Risk Money You Can’t Afford To Lose

“Can you afford to lose the money?” is the first question Megan asks her clients with stock options in private companies. The planning complication here revolves around the illiquidity of private company stock, which is neither registered with the Securities and Exchange Commission (SEC) nor listed on any trading market.

When you exercise stock options in a public company, you can typically sell shares at the time of exercise to pay the exercise cost and any taxes. You can’t do that in a private company. “When you exercise stock options in a private company, you will have to put out money to buy the shares,” Megan explains.

Moreover, as the stock acquired cannot easily be sold, you risk tying up that money in illiquid stock if the company does not go public or gets acquired—or losing it if the company fails. “For some people that risk may work, and for some people it may not,” cautions Megan.

Alert: If you are exercising your options while losing your job or moving on to another company, make sure you know your company’s rules on post-termination exercises. Vesting is likely to stop, and to avoid forfeiting the options you will probably need to exercise them either immediately or within a specified number of days after your termination date.

2. Remember You May Owe Taxes

You may be surprised to learn that income recognition and taxation at the time of an option exercise are not delayed by the lack of liquidity in private company stock. This is also true for the lockup period of the stock after an initial public offering (IPO). Therefore, Megan asserts, you must think ahead about paying the taxes you will owe after you exercise stock options in a private company.

Whether you have NQSOs or ISOs, any spread between the exercise price and the fair market value of the stock will require you to think about taxes. As with the exercise cost, you cannot sell any shares at exercise to pay taxes, as you can do with stock options in a public company. With NQSOs, for the required tax withholding your company may hold back shares, take the money from your salary, or make you pay it separately.

“Run some tax planning to understand what is going to happen here if you exercise,” Megan recommends. With ISOs in particular, she advises, be sure you know whether any spread at option exercise will trigger the alternative minimum tax (AMT).

3. Methods To Help You Avoid A Liquidity Crunch

Once you’ve exercised your stock options and acquired the shares, the money you paid is stuck in private company stock that cannot easily be sold. As private companies are now taking longer to go public or get acquired, they are increasingly sponsoring share liquidity programs, notes Megan.

“Your company may have an ongoing liquidity-type program, such as the one at SpaceX,” she says, adding that often these companies organize their liquidity programs through tender offers. (SpaceX regularly conducts secondary offerings and tender offers as a way for employees to sell equity.)

Megan also points out that resale markets have developed for employees with illiquid stock in private companies, including firms that can lend against private stock.

“The startup equity market has evolved,” she observes. “There is a segment of the startup market where you can get financing on your equity to help you with liquidity. There are providers out there that will work with you. But move slowly. Truly understand what you’re getting into.”

For more on this topic, see an article at myStockOptions: Financing Stock Option Exercises In A Private Company.

4. Consider Exercising Right Before The Company’s IPO

Of course, the ideal liquidity event for private company stock is either an IPO, in which the company becomes a publicly traded issuer listed on the NYSE or Nasdaq, or an acquisition by another company for a purchase price at a substantial premium.

If the company is preparing for an IPO, timing your option exercise just before the IPO could make a lot of sense, explains Megan. “Sometimes it’s really great to exercise private company stock options right as the IPO is happening, because you know the stock is going to go public. It’s a sure thing.” You can get yourself ready for it, she adds, and exercise at a time that may minimize risk.

“But know when the IPO lockup period ends,” Megan warns. After the IPO you will be unable to sell shares for a specified period, often up to six months. During that time the stock price could fall, raising another risk.

5. Planning Depends On Your Own Personal Circumstances

Remember that financial planning for stock options in a private company is complex. It must ultimately be built around your own personal circumstances, which may be very different than those of your colleagues. Consider the guidance of an advisor with experience in this niche.

“I can’t emphasize enough that this planning is very subjective,” Megan cautions. “It depends on the person, their risk tolerance, their finances, and their goals. Always move slower rather than faster with this planning.”

She urges clients to have a stock-selling strategy that plans for where the proceeds will go, and also reminds them to not let the “tax tail wag the financial planning dog” (i.e. don’t let taxes be the primary driver of your planning).

Further Resources

The webinar in which Megan and other top financial and tax experts spoke is available on demand on the myStockOptions Webinar Channel: Stock Option Exercise Strategies: Managing Risk & Building Wealth, also featuring Bill Dillhoefer (President and CEO, Net Worth Strategies) and David Marsh (Financial Planning Case Manager, Ameriprise Financial).

myStockOptions.com has an extensive section with resources on the special tax and financial planning issues for stock options in private companies.

CFPs, CEPs, And Others Can Now Get All Or Most Of Their CE Credits In myStockOptions Learning Center

Need CE credits? Wish you had a single easy place to get them?

Wish granted!

myStockOptions.com has expanded the valuable offerings in its Learning Center, a convenient resource that offers required continuing education (CE) credits for Certified Financial Planners (CFPs), Certified Equity Professionals (CEPs), Certified Private Wealth Advisors (CPWAs), and Certified Investment Management Analysts (CIMAs).

Our eagerly awaited new course on equity compensation at private and pre-IPO companies builds on the previously established programs about financial planning, taxation, stock options, restricted stock and restricted stock units, employee stock purchase plans, and SEC law.

New Course: Private & Pre-IPO Company Stock Compensation

The new course, Private & Pre-IPO Company Stock Compensation, is a timely addition in an age of huge demand for knowledge and resources in the complex realm of startup and private company equity compensation. Private companies have been growing fast over the past few years while granting increasing amounts of equity to their employees, whether via stock options or restricted stock units. Furthermore, the record number of initial public offerings (IPOs) and M&A deals in 2021 put a spotlight on the complex financial planning for equity comp and company shares that employees and their advisors need to know when a private company goes public or gets acquired.

myStockOptions Learning Center For Continuing Professional Education

The Learning Center at myStockOptions is a crucial resource for financial advisors and stock plan professionals who need to keep up their required continuing education on equity comp and earn the CE credits required to maintain their certifications. The eight courses in the myStockOptions Learning Center, each with a 30-question exam, now offer:

• 40 CE credits for CEP (over 100% of the total requirement)
• 26 CE credits for CFP (87% of the total requirement)
• 26 CE credits for CPWA/CIMA (65% of the total requirement)

Our CE courses not only demonstrate the practical expertise and excellence of our resources on equity comp. They add significant value to memberships at our websites, which have a big following among financial advisors, stock comp professionals, and stock plan participants. These are engaging online self-study programs that busy professionals can take at their convenience to obtain necessary CE credits.

The eight online self-study courses and exams:

• NEW! Private & Pre-IPO Company Stock Compensation
  5 CEP credits, 5 CFP credits, 5 CPWA/CIMA credits
• NEW! Taxation & Tax Reporting
  5 CEP credits, 3 CFP credits, 3 CPWA/CIMA credits
• Restricted Stock, RSUs, and Performance Shares
  5 CEP credits, 3 CFP credits, 3 CPWA/CIMA credits
• Nonqualified Stock Options
  5 CEP credits, 3 CFP credits, 3 CPWA/CIMA credits
• Incentive Stock Options
  5 CEP credits, 3 CFP credits, 3 CPWA/CIMA credits
• Employee Stock Purchase Plans
  5 CEP credits, 3 CFP credits, 3 CPWA/CIMA credits
• Financial Planning with Stock Compensation
  5 CEP credits, 3 CFP credits, 3 CPWA/CIMA credits
• SEC Law & Insider Trading
  5 CEP credits, 3 CFP credits, 3 CPWA/CIMA credits

Each course features articles, FAQs, podcasts, and videos from myStockOptions.com. They are woven into a dynamic, interactive learning tool that teaches the topics in a memorable way. The answer key for each 30-question exam also links to relevant content on the site for further reading and learning.

The value of our CE courses as efficient educational tools has also led some major financial institutions to use our Learning Center for internal training and their in-house certification programs.

Along with the Learning Center, the myStockOptions Webinar Channel also offers continuing education for the CFP, CEP, CPWA/CIMA, and EA certifications in its array of live and on-demand webinars.

Stock Options & RSUs From Startup To IPO Or M&A: Top Financial Advisors Cover 5 Key Topics

Fast-growing private companies rely heavily on equity compensation to recruit, motivate, and retain the best employees. Grants are typically stock options, restricted stock, or restricted stock units (RSUs). However, stock comp in private companies is surprisingly more complex and varied than what’s commonly used in mature public companies. The many challenges range from the inability to sell stock at exercise to fund the exercise costs to lockup restrictions on shares after the IPO.

A recent webinar held by myStockOptions.com presented practical guidance and case studies from three financial advisors with expertise in the financial and tax planning for private company equity awards and shares. Discussed in this article are five of the many topics covered.

1. When To Exercise Stock Options In A Private Company

At private companies in the early stages of growth, stock options predominate. By contrast, in public companies RSUs are more likely to be awarded for new-hire and annual grants. These startup company grants may include what are called “early-exercise stock options,” which allow you to buy the stock immediately. At exercise, you receive restricted shares that still must vest before you own the stock. Assuming a timely 83(b) election is made with the IRS, this comes with advantages and risks.

One potential benefit is “the ability to invest in the company early, possibly at a reduced tax cost,” as explained by webinar panelist Meredith Johnson, Director of Tax at BPM in San Francisco. “Exercising early converts future appreciation from ordinary income to capital gains and starts the clock toward a long-term holding period,” added panelist Devin Blackburn, a Senior Vice President at Northern Trust Wealth Management in Chicago. Exercising early also starts the holding period for the special 0% tax rate for qualified small business stock (QSBS).

But it’s important to note that early exercise is not for everyone. “I usually advise clients to wait to exercise private company stock options until they have to (e.g. changing jobs, options expiring) or possibly for an upcoming liquidity event,” said panelist Kristin McKenna, the Managing Director of Darrow Wealth Management in Boston. “Consider the time value of the money that would be used for option exercise—other ways to use that cash and other cash needs until the stock has liquidity.” That strategy was echoed by Meredith Johnson: “If there is embedded gain in the private company options, I typically recommend timing the option with a liquidity event (tender offer, etc.).”

2. Expect RSUs In A Later-Stage Private Company

As the private company matures and moves toward an IPO or acquisition, equity grants tend to shift toward restricted stock units (RSUs). You don’t exercise RSUs, unlike stock options. Once the RSU vesting conditions have been met, the shares are delivered to you.

While RSUs in public companies typically have just one vesting requirement (e.g. length of employment from time of grant), RSUs in private companies have “double-trigger” vesting. In other words, two conditions rather than just one must be met before the RSUs vest and the underlying shares are delivered to you. “Usually time is the first trigger, and an event such as an IPO or a company acquisition is the second and final trigger,” explained Meredith Johnson.

Crucially, you cannot control the timing of taxation with RSUs, as you can with stock option exercises. This raises a myriad of tax-planning issues, leading to the next topic.

3. Need A Plan For The Taxes On Equity Comp

When you receive stock in a private company, whether by option exercise or RSU vesting, the IRS and the SEC don’t care that you can’t sell the shares to pay the taxes owed. The same tax rules apply to illiquid private company stock as to freely tradeable public company stock. Therefore, before a stock option exercise or RSU vesting date, you need a way to pay the taxes that you may owe.

With incentive stock options (ISOs), when you exercise and then hold the shares you need to consider the alternative minimum tax (AMT). Plus, while no withholding applies with ISOs, even when you can sell some of the shares, that doesn’t mean you may not owe taxes! With nonqualified stock options (NQSOs), you have withholding and taxable compensation income for the spread at exercise, plus Social Security and Medicare taxes (FICA). With double-trigger RSUs, you will face compensation income when all the vested shares are delivered in one batch at the specified time after the second trigger, and then also the FICA taxes when the IPO occurs.

Depending on your tax bracket, the flat federal withholding rate on stock compensation may not be enough to cover the total tax you really owe on the value of the shares you receive. (The rate is 22% for yearly supplemental wage income up to $1 million and 37% for amounts over that.) In this case, you need to think about paying quarterly estimated taxes, making adjustments in your salary withholding, or at least plan to pay extra taxes (and potential penalties and interest) with your tax return for the year.

All of the webinar panelists emphasized that not considering the tax impacts is an especially big mistake with private company stock comp. As Devin Blackburn put it: “lack of planning for the dreaded ‘liquidity crush’—you’re wealthy on paper but have a persisting cash deficit.” You need to think about “how to pay tax without liquidity,” Kristin McKenna reiterated.

4. Actions Before And After The IPO Lockup

Some companies, such as Airbnb, Robinhood, and Snowflake, have allowed employees to sell a small percentage of shares at the time of the IPO and/or shares later before the expiration of the lockup. However, in general, you may not be able to sell any shares for up to six months after the IPO date (and often longer with SPACs).

Plus, if you’re a company executive or key employee who often knows material nonpublic information, you may also be subject to frequent blackout periods. That is when the company prohibits you from selling stock and thus potentially committing insider trading. That creates the need to consider the use of Rule 10b5-1 trading plans.

This is another planning area where mistakes can easily occur. “Understand the attributes of all your grants, share holdings, the lockup period, and any blackout periods,” explained Devin Blackburn. She also emphasized the need to “model various scenarios that reflect multiple price targets to manage expectations and emotions.” For example, with unexercised ISOs, when about six months from the IPO, evaluate exercising and holding pre-IPO. Although this may trigger the AMT, after the lockup ends you can then sell the stock, with all the sales proceeds over the exercise price getting taxed as long-term capital gain.

This is the time to tie everything together about your grants and stock holdings. “Calendar the IPO, lockup, sales windows, and tax payments so that you can better coordinate sufficient liquidity to meet your tax obligations,” added Meredith Johnson. “Understand the immediate tax impact of an IPO (double-trigger RSUs) and whether there is an opportunity to opt in to alternative tax withholding. Review vesting schedules, early-exercise provisions, and consequences of separation from service.” She suggests a goals-based planning model that considers appropriate cash needs to determine a client’s sales strategy.

Kristin McKenna recommended that you “use the calendar year to your advantage.” This can help you decide whether it’s time to take profits and risk off the table, such as selling before year-end, which also avoids any AMT on ISOs exercised early in the year. She also urges her clients to get organized with separate bank account for taxes and cash to exercise, while tracking the lockups’ end and any special milestones, such as those related to an acquisition vesting or payout.

5. Lessons Learned From The Recent Big Wave Of IPOs, M&A, And Startup Financing

There has been a “sheer explosion of IPOs” over the past year, noted Devin Blackburn. “They are up more than 650% compared to a year ago.” Like many of their colleagues, the advisors on the webinar panel have been thoroughly battle-tested by guiding clients from the startup stage through the hectic climax of an IPO or acquisition, and then in the newly acquired wealth beyond. “Never assume that someone with a tidal wave of wealth has an adequate team, wealth plan, or estate-planning documents,” added Devin. “Founders, employees, and early investors need guidance.”

“Client education and communication are particularly important for clients who are unaccustomed to working with professional advisors,” observed Meredith Johnson. “Have the uncomfortable discussion about market risk—founders in particular see their stock in a rosy light.”

“Recognize that things can change quickly,” warned Kristin McKenna. “The market for IPOs and M&A can change rapidly, and stocks don’t just go up.” She advises her clients to “focus on what you can control.” Controllable factors she emphasizes include portfolio diversification to manage the risks of concentration in your company’s stock. They also include carefully watching “lifestyle inflation,” i.e. the growth of spending with sudden new wealth.

Further Resources

The webinar in which these advisors spoke is available on demand at the myStockOptions Webinar Channel. In addition to what’s covered in this article, the advisors addressed numerous advanced topics, such as estate planning, SPAC acquisitions as way to go public, and company-sponsored liquidity sale programs (e.g. tender offers) for later-stage private companies. The sections Pre-IPO and M&A at myStockOptions also cover a range of topics on the financial and tax planning for equity comp in private companies.

myStockOptions Webinar Channel

See the myStockOptions Webinar Channel for upcoming webinars and past webinars on demand. Each on-demand webinar (100 mins) offers 2.0 CE credits for CFP, CPWA/CIMA, and CEP:

Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition: Equity comp in private companies is different. Learn the related financial and tax planning with three leading financial advisors, including real-world case studies.

Restricted Stock & RSU Financial Planning: Advanced Bootcamp: Insights from a panel of three leading financial advisors, including case studies, to provide practical expertise for restricted stock/RSUs in public and private companies.

Stock Option Exercise Strategies: Advanced Bootcamp: It is crucial to have a plan for stock option exercises. This webinar features compelling strategies from a panel of three experts in financial and tax planning for option exercises.

Stock Compensation Bootcamp For Financial Advisors: Whether you are new to stock comp or want to sharpen your knowledge, our bootcamp webinar provides practical information and insights to maximize success.

Strategies For Concentrated Positions In Company Stock: Wealth is won and lost through the management of concentrated company stock positions. In this webinar, experts at managing concentrated stock wealth explain strategies and solutions.

10b5-1 Trading Plans And Other SEC Rules Advisors Need To Know: Learn the fundamentals, best practices, and most effective designs for Rule 10b5-1 trading plans. This webinar features top legal and financial experts presenting practical guidance and real-world case studies for financial advisors.

Financing Stock Option Exercises In A Private Company: A Financial Advisor's Guide

Many private companies are growing fast, with the intention to go public or be acquired. They tend to rely heavily on stock options or restricted stock units (RSUs) to attract, motivate, and retain the best employees. However, employees with stock compensation in a private company, whether in startup, growth, or pre-IPO phase, face a big obstacle that their counterparts in public companies do not.

The stock of private companies has no liquidity, as it's not listed on stock exchanges and resales are restricted by both SEC and company rules. In other words, you cannot sell your shares, even to pay taxes owed on them or to help fund the exercise of stock options. Stock options in private companies can create wealth; but unlocking its value when the stock has no immediate liquidity calls for special planning.

For insights on what you can do, and the growth in firms that provide financing to exercise private company stock options, we asked Valerie Gospodarek, CFA, an independent financial advisor with over 25 years of experience in the finance industry. She specializes in helping clients with their executive compensation, including stock options, restricted stock, and deferred compensation plans.

What is different about exercising stock options in a private company?

When you receive stock options from a company that is publicly traded, you have much greater flexibility in how to exercise them. Among the various exercise methods available, you can choose a “cashless” or “sell-to-cover” exercise, requiring no upfront payment. With these types of exercises, two transactions actually take place, although they happen practically simultaneously and are often viewed as just one. The first transaction consists of purchasing the shares at the exercise price. The second transaction consists of then selling all those shares (or a portion of, in the case of a “sell-to-cover” exercise) at the current market price and using the proceeds to pay for the share purchase in the first transaction and withhold any required taxes (for nonqualified stock options, not for incentive stock options).

With a private company, you can execute the first part of the exercise transaction—purchasing the shares at the exercise price. However, because the shares just acquired have no public market in which they can be sold and are not registered with the SEC, you cannot use the second part of the transaction (selling the shares) to finance the first part (purchasing the shares and paying any taxes).

How does this challenge for private company employees affect their ability to maximize the benefits of stock options?

It means you must come up with the cash required to both purchase the shares at the exercise price and pay for any tax withholding. The price to exercise (and the corresponding taxes) can be significant, and often employees don’t have this large sum of cash readily available to cover these costs. Even if purchasers for these private company shares exist, the company’s stock plan documents often restrict these types of resale transactions.

Do employers provide any financing for option exercises and the corresponding taxes?

Private companies may provide loans to their employees for the purpose of exercising their options, but I do not generally recommend this alternative to my clients. Should the company fail, creditors of the company can, and most likely will, aggressively seek repayment of these loans. At that point, the optionholders then find themselves without a job AND obligated to repay a loan on worthless shares of the company’s stock.

It is worth knowing that if you do use a promissory note from your employer to exercise your stock options and it is a nonrecourse note (i.e. no personal liability if you default), it is not considered an exercise for tax purposes until the note is substantially paid. When the promissory note is with a third party (e.g. a bank) and the stock is pledged as collateral, this is considered an exercise and the standard tax treatment at exercise applies, even if the stock price drops and you default on the loan.

How do you help a client think through whether to self-finance an exercise?

Clients not only need to have the ability to self-finance, but also the willingness. Therefore, the first topic I typically discuss with clients is their prospects for the company, including their expected upside/downside potential for the business and stock, and the anticipated timing for a liquidity event (i.e. IPO or acquisition).

I’ve found that most employees are typically quite bullish about their employer’s prospects, so I often play devil’s advocate to try to temper their overly bullish outlook and come to more reasonable expectations. As part of this discussion, I ask the client how much they would be willing to invest in their company knowing that there is a chance that it could go to zero.

Clients must be comfortable not only with the possibility of losing their entire investment but also with the fact that they will not get back any of the taxes they paid to exercise those options that are now worthless shares of stock. While this is particularly relevant if the employer is in its early stages and any potential liquidity event is several years away, it is a scenario that all optionholders should consider before investing their own capital. If this risk of loss will keep the client up at night, then it likely makes more sense to consider outside financing.

When a client decides to self-finance the exercise, how do you help them decide how to do it (e.g. from savings, borrowing from relatives, a home equity loan)?

When we have determined that a client’s employer’s prospects are attractive and that the client is willing to accept the risk of investing their own funds, then we will review the client’s ability to self-finance by looking at their current savings and cashflows. When it’s determined that there is cash remaining after a client’s expenses are met for the next 2–3 years, we will discuss the pros and cons of using their reserves to exercise their options.

If the anticipated timing for a liquidity event for the stock is within a year and the potential upside is significant, then I will likely recommend that they self-finance the exercise and retain all the potential upside, rather than committing a significant portion of it to an outside financing company. If the liquidity event is 1–2 years away, we will discuss a combination of self-financing and outside financing.

If clients do not have cash available to fund such an investment, but it still makes sense to self-finance, we will then look at their other assets that might be able to fund the option exercise. In this case, they may have other taxable investments trading at losses or minimal gains where the upside potential is less than that of their private company stock. I generally do not recommend that clients take loans against, or cash out, retirement plans to generate cash, as these tend to be more expensive and risky ways to raise funds.

If clients do not have cash or other investments available to finance their option exercises, we will then discuss the advantages and disadvantages of using traditional loans, especially home equity loans if they have significant equity in their primary residence. However, while it is difficult to beat the low interest rates on home equity loans currently, many traditional lenders will not allow for loan proceeds to be used for investments, limiting their use as a source of funds to exercise stock options. In addition, clients must be comfortable with the fact that should their company stock go to zero, they still need to repay the amount they were loaned to purchase those now worthless shares.

Relatives may be willing to provide loans to clients for the purpose of exercising their stock options, and these loans may have more attractive terms than those from outside financing companies. If this is the case, we will discuss not only the terms of the loan, but how borrowing from a relative may affect their future relationship with that relative. If the terms are better than what would be owed to an outside company, and the client is confident that accepting and possibly not repaying the loan will not damage their relationship if the company fails, then I will likely support this alternative.

If none of these alternatives for self-financing or family financing make sense for the client, then we will discuss funding the exercise wholly with outside financing.

Have there always been outside companies that specialize in provide financing for exercising stock options?

A whole cottage industry has sprouted up over the past decade that provides financing capital to private company optionholders. This industry has become quite large over time, with one of the largest financing companies having provided funding to employees at 80% of all US-based “unicorn” startups just since January 2020.

What are some of these providers of outside financing for private company option exercises?

Some of the larger, more prominent providers include (in alphabetical order) Equity Bee, ESO Fund, Liquid Stock, Quid, and SecFi. An internet search of “stock option financing” and/or “stock option lenders” will result in these and several other financing firms.

How does this type of financing work? Are these financing companies actually investing in the stock options or just lending to employees to exercise them?

These financing companies may provide the financing themselves if they manage a private equity or hedge fund for this purpose, or they may just act as an intermediary, connecting investors to optionholders. Either way, the financing company delivers the funds employees need to exercise their options themselves and pay the corresponding taxes.

It is important to note that these financings are not traditional loans that have annual percentage rates and fixed repayment dates. They are contractual agreements where the optionholder agrees to repay the funds (plus fees and some of the stock’s upside—more on this later) after the stock becomes liquid, such as after an IPO.

Many of these financings are “nonrecourse,” meaning that should the company fail, the optionholder is not responsible for paying back the financing amount. Because the financing company is bearing the risk of not being repaid, it will want to review the optionholder’s company for its potential upside, similar to how investors research which publicly traded stocks to invest. This may or may not require that the optionholder’s company share nonpublic information, including financial data.

The contract between the financing company and the optionholder is initially based upon the optionholder’s willingness to repay the financing amount plus the agreed upon upside and fees, since most shares acquired upon exercise are not typically able to be used as collateral due to restrictions in the company’s stock plan documents. The financing amount plus the agreed upon upside and fees are generally repaid after any lockup period has expired and the optionholder is able to dispose of their shares in the public market.

Do the terms of these agreements differ by the company providing the financing?

There are nuances in how each company structures their financing. For example, some may charge an additional fee for “brokering” a deal, in other words finding investors interested in providing the financing. In these cases, that fee would be in addition to the upside paid at the end of the lockup period. Other financing firms may only agree to provide financing if the optionholder’s employer agrees to allow it access to other optionholders within their company. Still other firms may require the shares become collateral for the financing once any lockup period has ended.

Does an employee lose some of the upside in using this outside financing?

Yes. Optionholders can generally expect to give up one quarter to one half of the stock’s upside on average, including fees, with these types of financings. For an example of how this works, see Exhibit 3 in Stock-Option Financing in Pre-IPO Companies (Rock Center for Corporate Governance at Stanford University Working Paper Forthcoming).

This upside (and fees) is what the financing company receives for taking on the risk of the company potentially failing, as discussed earlier. Every financing deal will be priced differently depending upon the specific circumstances, including, but not limited to, the perceived upside of the stock, the length of time expected until a liquidity event for the stock occurs, and the amount of financing provided.

Does using outside financing change the tax treatment at exercise?

Generally speaking, no, but some of the arrangements may allow for the amount paid by the optionholder to the financing company above the initial financing amount to qualify as a capital loss, potentially offsetting gains from selling shares. These financing structures are complicated, though, so I always recommend that clients consult with a tax professional who specializes in stock compensation before entering into any stock option financing contracts.

What are the pros and cons of using an outside financing company to exercise?

One of the largest advantages is optionholders’ ability to exercise their options without having to self-finance with what could be a very significant outlay of cash. This is of particular benefit if employees are facing potential forfeiture of their vested options without the funds to exercise them, for instance if leaving their company for another job. Another benefit is not losing one’s own money or having to repay a nonrecourse financing should the employee’s company fail and the stock goes to zero. Lastly, obtaining outside financing may allow the optionholder to exercise their options earlier than without that funding. Taxes can be significantly lower by exercising early, particularly when the stock price is low after grant. Early exercises also start the capital gains holding period for future sales of the stock to qualify for the lower long-term capital gains tax treatment (versus ordinary income).

Giving up a portion of the stock’s upside (plus fees) if the stock ends up being very successful is obviously the biggest detractor to receiving outside financing. In addition, the added tax complexity that can arise from complicated structures used by outside companies in providing financing can result in significant tax consulting and preparation fees.

Additional Resources

See the section Pre-IPO at myStockOptions.com for more information and insights on financial planning for employees in private and pre-IPO companies. myStockOptions has also held a special webinar on these topics: Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition (available on demand at the link).

myStockOptions Webinar Channel

See the myStockOptions Webinar Channel for upcoming webinars and past webinars on demand. Each on-demand webinar (100 mins) offers 2.0 CE credits for CFP, CPWA/CIMA, and CEP:

Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition: Equity comp in private companies is different. Learn the related financial and tax planning with three leading financial advisors, including real-world case studies.

Restricted Stock & RSU Financial Planning: Advanced Bootcamp: Insights from a panel of three leading financial advisors, including case studies, to provide practical expertise for restricted stock/RSUs in public and private companies.

Stock Option Exercise Strategies: Advanced Bootcamp: It is crucial to have a plan for stock option exercises. This webinar features compelling strategies from a panel of three experts in financial and tax planning for option exercises.

Stock Compensation Bootcamp For Financial Advisors: Whether you are new to stock comp or want to sharpen your knowledge, our bootcamp webinar provides practical information and insights to maximize success.

Strategies For Concentrated Positions In Company Stock: Wealth is won and lost through the management of concentrated company stock positions. In this webinar, experts at managing concentrated stock wealth explain strategies and solutions.

Private Company Stock Grants: Recent SEC Filings By Uber And Other IPO Companies Reveal Plan Design Trends

Uber, Lyft, Pinterest, Zoom: Some major private companies in the tech sector have recently gone public or are about to. This is a big moment for their employees who have stock grants. A question we at myStockOptions.com are often asked: How do stock grants work in privately held companies?

Filed with the Securities & Exchange Commission (SEC), the Form S-1 registration statements of IPO companies show trends in these grants. These filings also reveal that the stock options and restricted stock grants that private companies make are often more complex than the standard types of grants used by public companies.

Typical Stock Options And Restricted Stock

The standard variety of employee stock options allows you to exercise the options only when they have vested, usually after you have worked at the company for a specified time. With restricted stock and the now more commonly used restricted stock units (RSUs), the event that triggers vesting is employment for a set period after the grant date and/or perhaps the attainment of specified company performance goals.

Example: You have a grant of 10,000 stock options or RSUs that vest 25% after the first anniversary of the grant, and then 25% yearly for the next three years (i.e. four-year annual vesting). After the first year 2,500 options vest and are exercisable (or 2,500 RSUs vest), and a similar number vest annually from there.

Private Company Stock Options And RSUs Can Be Different

One big difference in private companies is the illiquidity of the stock. Employees cannot sell shares at exercise or vesting, even to pay the taxes owed on the income recognized. This lack of liquidity, along with securities-law restrictions on resales of stock, does not delay the tax-measurement date at option exercise or restricted stock vesting.

Given the vastly differing liquidity situations of private and public companies, having the same tax treatment for stock grants at pre-IPO and large publicly traded companies seems out of balance. To address this issue, a provision in the Tax Cuts & Jobs Act (tax reform) created “qualified equity grants” for private companies under the new tax code Section 83(i). While this alters the standard tax treatment when various conditions are met, in its current form this provision will get little use. (For details, see our past blog commentary on it.)

However, long before this provision came along, smart lawyers and accountants had already come to the rescue. Operating within the existing tax laws and IRS regulations, they developed new structures for stock option grants and RSUs at private companies that work around the standard tax treatment. You can see this widespread use in a review of the Form S-1 registration statement filed with the SEC by Uber Technologies (April 11, 2019 draft), and in the effective registration statements for the now-public companies Lyft, Pinterest, and Zoom Video Communications.

Early-Exercise Stock Options

One of these equity innovations for employees at private companies is early-exercise stock options. Instead of letting you exercise options only after the vesting date, when you might face a big taxable spread between the exercise price and the fair market value of the stock, the company instead grants options that are immediately exercisable. When you exercise the options, you receive restricted stock with a vesting schedule identical to that of the option grant. Until vesting occurs, if your employment ends your company has a repurchase right in the stock.

The advantages to these types of option grants is that you exercise when the spread is $0 or very small and start the capital gains holding period. A major risk is that to profit from these options you need the shares to become liquid, whether through an IPO, M&A deal, or private resale market. Uber seems to have used early-exercise stock options in its initial stock plans (see pages F-8 and F-55 of its S-1 registration statement), as did Zoom (see pages 101-105, F-6, and F-29 of its S-1).

Alert: To get this tax treatment, you should make a Section 83(b) election and file it within 30 days of exercise with your local IRS office, whether you are exercising nonqualified stock options (NQSOs) or incentive stock options (ISOs).

Restricted Stock Units With Double-Trigger Vesting

Larger, later-stage pre-IPO companies often grant RSUs instead of stock options for many reasons, including concerns about dilution and about high valuations which could lead new option grants at that exercise price to go underwater. This shift from stock options to RSUs is found in Uber’s registration statement. See the tables below from page F-56 of its Form S-1. These show a big difference between the number of stock options recently granted and the number of RSUs granted.

Vesting Structure Impacts RSU Taxes

The standard tax treatment of RSUs triggers taxes at vesting. However, because a private company's stock is illiquid, employees at private companies cannot sell shares to pay those taxes. In this situation, some private companies with enough cash may either lend employees money for the taxes or provide a cash bonus that covers them (this can be done for stock options too). But many private companies now structure their RSU grants to add  a second vesting provision, which requires a liquidity event for the grant to fully vest.

For example, in various places in Uber's Form S-1 (e.g. pages 15, 108, 142) and in Pinterest's S-1 (e.g. pages 7, 32, 76, 82), the filing states that RSU grants (and some options) have both service-based vesting and liquidity-event-based vesting. Some employees meet both conditions immediately after the IPO, facing a big tax bill, and others just the second condition. The big downside to this structure is that suddenly employees owe huge taxes on shares that are likely to be much higher in value than when the grants were made.

Employees are also then bumped up into the top tax brackets for all their other income, whether salary or capital gains, because of this income hit from the IPO timing that they cannot control. Lyft reveals a 42% withholding rate (page 15) while Pinterest used 48% (page 11). Should your grant fully vest in an IPO, welcome to the top income-tax bracket (though hopefully also a high level of wealth).

Tax Withholding

Most companies automatically withhold shares from the grant to pay the taxes owed, sometimes referred to as net settlement. Employees do not need to come up with the cash, though some would like to keep the shares instead of this indirect form of diversification through share withholding. The obligation of the company to fund the tax liabilities with the withheld shares, which requires the company to send cash and not shares to the IRS to pay it, can create an onerous financial and administrative burden for the company.

Companies often disclose that funding withholding taxes is one of the uses for IPO proceeds. This could affect a company’s financial condition or add to dilution, according to risk factors disclosed by companies, as in Uber’s SEC filing (see page 69). Alternatively, companies can allow for stock sales for taxes by employees as an exception to the lockup, as Uber discloses on page 266.

Additional Resources On Private Company Stock Grants

For more information about stock grants in pre-IPO and post-IPO companies, see the section Pre-IPO at myStockOptions.com. For a one-day live event covering these topics, consider attending the myStockOptions.com national conference in San Francisco (details below).

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• Equity compensation planning challenges relating to taxes, wealth preservation and transfer, and charitable giving
• Significant tax, legal, and SEC compliance pitfalls to avoid, and new developments
• Financial planning for equity comp in pre-IPO companies
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Private Company Grants Of Stock Options & RSUs: IRS Guidance Provides Limited Support

Equity compensation in privately held companies is tricky for both employers and employees because the companies’ stock is not publicly traded and is therefore illiquid. Introduced by a complex provision of the Tax Cuts & Jobs Act (“tax reform”), which took effect this year, a new section of the tax code, Section 83(i), seeks to make equity comp more appealing to private companies. It lets them make grants of nonqualified stock options (NQSOs) or restricted stock units (RSUs) in which the recipient can defer income taxes for up to five years from NQSO exercise or RSU vesting as long as the grants meet certain conditions. These are called “qualified equity grants.”

However, the initial reaction by private companies to this new opportunity has been cautious and cool. Before plunging in, many have awaited clarification and guidance from the IRS on the many technical requirements and details of the new grant type. In Notice 2018-97, the IRS finally issued guidance for companies on qualified equity grants, with more to come, but it may do little to enhance the appeal of these grants for smaller startups.

The Tax Problem Congress Wanted To Solve But Only Made More Complicated

While stock options and restricted stock units are popular at startups and other pre-IPO companies, employees cannot sell stock at exercise or vesting, even to pay the taxes owed on the income. The IRS confirmed in regulations issued during 2014 that the tax measurement date (at exercise for options and at vesting for restricted stock) is not delayed by any lack of liquidity or securities law restrictions on resales of stock.

The fact that the tax treatment for stock grants at pre-IPO and large publicly traded companies is identical seems oddly unfair when you consider the vastly differing liquidity situations of private and public company employees. While private companies want to use equity grants to motivate, retain, and create employee-shareholders, they do not want to obligate their employees to pay taxes on shares they cannot sell. Seeking to ease this conundrum, Congress first considered the Empowering Employees Through Stock Ownership Act. That bill eventually transformed into part of the Tax Cuts & Jobs Act. To provide for qualified equity awards, it added Section 83(i) to the Internal Revenue Code.

Qualified Equity Grants: Outline Of New Tax Deferral

Instead of automatically delaying when taxation occurs after employees receive illiquid private company stock as compensation, Section 83(i) imposes elaborate rules on what types of grants qualify, what types of employees qualify for these grants, employee deferral elections, and procedures companies must follow. The table below summarizes some of the main features of the new Section 83(i).

Key Facts For Tax Deferral Of Private Company Stock Grants

Eligible types of stock compensation	NQSOs and RSUs
Tax deferred	Federal income tax
Deferral period	Five years, unless triggered earlier
Election required	83(i) election within 30 days of exercise or vesting
Company requirements	Numerous, including grants to 80% of employees

For more details on this tax code provision, see our related article: Private Company Stock Options And RSUs: 10 Facts To Know About The New Tax-Deferral Opportunity.

Three Topics IRS Guidance Addresses

In Notice 2018-97, the IRS clarifies and creates rules in three areas that are evidently the most pressing for companies.

1. Time requirement for the 80% rule. To make qualified equity grants, the company must issue grants to at least 80% of employees in a single calendar year. The law does not provide for a cumulative basis that considers grants from prior years. Apparently, the IRS felt it had to go with the statutory language.

Potential impact: This makes it more difficult for early-stage startups, as they primarily make new-hire grants, not annual grants that can more easily fit into a calendar year. For example, imagine a 10-employee startup in which everyone gets meaningful grants at hire. Next year, the company hires two more employees, who also get meaningful grants. Although 100% of employees have equity awards, the company made grants to only 20% in that year, and therefore those grants cannot be tax-qualified. Don’t blame the IRS for this outcome until Congress amends the law.

Big private companies, such as the Unicorns (e.g. Uber, Airbnb), along with other large late-stage pre-IPO companies that make broad-based grants, will find it easier to meet the 80% rule. Their grant practices have probably evolved to become more regular, with annual and bonus grants.

2. Tax withholding. Companies must set up a procedure to escrow the deferred shares employees receive at exercise with options or vesting with RSUs. They then use some of the shares to pay the withholding tax that is eventually due after five years or a liquidity event. Employees must agree to this arrangement at the time of their deferral election.

Potential impact: This new requirement, not stated in the new law, addresses company and IRS concerns about how the taxes will be paid. This becomes a big issue if no liquidity event occurs or when ex-employees cannot be located. The approach does add more costs, procedures, and communications to what companies are obligated to implement.

The requirement makes qualified equity grants more appealing to well-established private companies that are likely to go public or get acquired. They have the resources to set up this type of arrangement. Their employees also assume less risk and thus more potential benefit with the deferral, as they are acquiring stock that has demonstrated value and the potential for liquidity within the five-year deferral period.

3. An opt-out: Companies can designate grants that are ineligible for the employee deferral election. They do this by not setting up the share escrow arrangement or not following other conditions for qualified equity grants.

Potential impact: Companies were concerned that they could unintentionally meet the conditions allowing employees to make a deferral election, potentially causing the company to be penalized for not following the new law’s requirements for employee notices and communications. While the IRS guidance clarifies how companies can opt out of the provision, the pressing need for IRS guidance on how to opt out suggests companies are not eager to make these type of stock grants. Early-exercise stock options or vesting conditions that require an IPO or acquisition will probably remain more popular ways to specially structure stock grants at private companies.

For more information about the taxation of stock options and restricted stock/RSUs, see the Tax Center at myStockOptions.com. The website’s section on pre-IPO companies covers topics related to stock grants at private companies.

Legislative Update: Empowering Employees Through Stock Ownership Act Resurfaces In The Senate

Alert: A version of this bill was enacted as part of the Tax Cuts & Job Act, though with a five-year deferral period. See our blog commentary on the adopted legislation.

While stock options continue to be popular at startups and other pre-IPO companies, employees cannot sell stock at exercise to pay the exercise price and the taxes on the income. Moreover, under current law those taxes cannot be delayed. Last year, an encouraging legislative proposal was introduced in the House of Representatives to address this issue. Approved by a House vote in September 2016, the Empowering Employees Through Stock Ownership Act (HR 5719) sought to give employees in pre-IPO companies extra time to pay federal income taxes on the spread at exercise with nonqualified stock options and on the income at vesting with restricted stock units. (See the myStockOptions blog commentaries in July 2016 and October 2016.)

Under the proposal, the permitted deferral of taxation would be considerable. The legislation would allow an employee to defer taxes for up to seven years as long as the company's equity awards met certain conditions (for example, "Qualified Equity Grants" would need to be made to at least 80% of employees). In the feedback we at myStockOptions.com receive from stock plan participants and financial advisors, we understand that the current tax treatment does deter employees from exercising options and becoming true company owners. Although the proposal appears to be good news for employees at private companies who have equity comp, some provisions in the law could hinder its effectiveness, as we explained in our commentary on HR 5719 last October.

After its House approval last year, the Empowering Employees Through Stock Ownership Act went to the Senate, which did not take it up. However, in late June 2017, it was reintroduced as a separate bill with the same title in the Senate (S.1444). The Senate legislation is very similar to the House bill of last year and has bipartisan support: Its sponsors are two members of the Senate Finance Committee, Mark Warner (D–VA) and Dean Heller (R–NV), and two members of the House Ways and Means Committee, Eric Paulsen (R–MN) and Joseph Crowley (D–NY). Details of the proposals are available in the press release on it that was issued by Senator Warner's staff.

Although more than 70 companies have expressed support for the legislation, the prospects for its enactment remain somewhat uncertain in the current Congress, which seems to be preparing for a major effort at comprehensive tax reform (see the myStockOptions FAQ on how that could affect stock compensation). One obstacle could be finding a way to offset the cost of the proposed tax provisions. Although the legislation would allow only the deferral of taxes, not their elimination, the delay in tax payment would impose a revenue cost on the federal government.

Legislative Update: Senate Considering Tax Change For Options And RSUs In Pre-IPO Companies

Alert: A version of this bill was enacted as part of the Tax Cuts & Job Act, though with a five-year deferral period. See our blog commentary on the adopted legislation.

We wrote a blog commentary in July about the Empowering Employees Through Stock Ownership Act (HR 5719), which was subsequently approved by the House of Representatives, through a vote of 287 to 124. The bill is now in the Senate for consideration. In short, HR 5719 seeks to give employees in privately held companies extra time to pay taxes on the income they recognize at option exercise or RSU vesting. Instead of paying taxes at the exercise of nonqualified options or at the vesting of stock-settled RSUs, employees would be allowed to elect to defer the resulting income, and thus the taxes on that income, for up to seven years.

A staff member for Congressman Erik Paulsen (R–MN), the bill's leading sponsor in the House, told myStockOptions that "Rep. Paulsen is hopeful that the Senate will pass the legislation soon and that it will make its way to the President's desk sometime in the lame-duck session, either as a standalone bill or as part of a larger package." He added that Rep. Paulsen is not aware of any timetable for Senate consideration. When we checked with the office of Senator Mark Warner (D–VA), a leading sponsor of the bill in the Senate, his staff confirmed that the legislation had just been introduced. With Congress now in recess ahead of the general election on Nov. 8, it is very unlikely that anything will happen with the legislation until after the election. There is a chance that the bill will be adopted during the lame-duck session, a busy time when many laws with populist intentions tend to be hastily enacted while the outgoing president is still in office. At Congress.gov, you can follow the progress of the legislation in the House and the Senate.

Details Of The Proposed Law Could Unintentionally Discourage Its Effectiveness

In general, we support a beneficial tax-law change for equity awards at pre-IPO companies and favor broad-based stock plans. However, in the report on the bill from the House Ways & Means Committee (see pages 10–14, "Explanation of Provision"), we do see some aspects of the legislation that might somewhat dampen enthusiasm for the proposed tax-qualified grants. The tax deferral would not apply to Medicare, Social Security, or state taxes. It would not apply to early-exercise options. As we interpret it, the deferral election apparently would turn ISOs into NQSOs. Furthermore, clarifications are needed on various aspects of the proposed law. For example, the House report states that an "inclusion deferral election" would be required within 30 days of vesting but does not mention that for options the election would need to be 30 days from exercise (not vesting). Also, the numerous rules that companies would have to follow to grant what the bill calls "qualified stock" might make these awards appealing only to large pre-IPO companies and not to true early-stage startups.

Moreover, companies currently already have a way to structure pre-IPO RSU grants so they do not trigger taxes until there is a liquidity event. Without liquidity and the ability to trade their stock, employees who exercise options in pre-IPO companies face the risk of tying up their money in stock that could be worthless. The proposed tax-deferral feature includes a seven-year period before taxes are owed, but for some employees this may not be long enough to encourage them to exercise options and create the widespread employee ownership that the bill wants to promote.

For additional analysis on the bill and the issues it raises, see a commentary from the consulting firm Compensia and an article by columnist Kathleen Pender in the San Francisco Chronicle.

Stock Options In Startup Companies Could Become More Popular Than Ever Under Proposed Tax Change

Alert: A version of this bill was enacted as part of the Tax Cuts & Job Act, though with a five-year deferral period. See our blog commentary on the adopted legislation.

Stock options continue to be very popular at startups and other pre-IPO companies, where they are often broadly granted to most or all employees. While these options can have wealth-creating potential, one big challenge is lack of liquidity: employees cannot sell the stock at exercise to pay the exercise price and any taxes owed. As the IRS confirmed in regulations issued during 2014, the tax measurement date (at exercise for options and at vesting for restricted stock) is not delayed by any lack of liquidity or securities law restrictions on resales of stock.

The fact that the tax treatment for stock grants at pre-IPO and large publicly traded companies is identical seems oddly unfair when you consider the vastly differing liquidity situations of private and public companies. Seeking to address this imbalance, recently proposed bipartisan legislation could provide a new optional tax treatment (pun intended) and make stock options more appealing than ever at startups and other pre-IPO companies. Introduced in the House of Representatives and the Senate on July 12, as explained by an article at The Hill, the Empowering Employees Through Stock Ownership Act seeks to give employees in privately held companies extra time to pay taxes on the income they recognize at exercise. The proposed extra time is considerable. Instead of paying taxes at exercise with nonqualified options (or at RSU vesting when settled in stock), this legislation would allow tax deferral for up to seven years.

Senators Mark Warner (D–VA) and Dean Heller (R–NV), members of the Senate Finance Committee, sponsored the bill in the Senate, while Representative Erik Paulsen (R–MN) is the sponsor in the House. In the press release supporting the bill, Sen. Warner states that "extending employee stock programs to a broader universe of workers will strengthen business growth and create new economic opportunities, especially for rank-and-file workers." For his part, Sen. Heller asserts that "it's important to give employees the flexibility to pay their taxes on stock options."

Company And Employee Requirements

To make the new deferral election available (under Section 83 of the Internal Revenue Code), a company would have to issue what the bill calls "Qualified Equity Grants." These grants would need to be made to at least 80% of the company's employees annually. The company would have to provide information or a warning about the tax impact, especially if the share price should decline, and it would be required to report future tax liability on each employee's Form W-2. Qualified grants would be unavailable to major owners, corporate officers, and the highest-paid executives.

Sounding in some ways similar to the procedure for the Section 83(b) election, the deferral election for qualified equity grants would need to be made by employees within 30 days of either when the shares became transferable or when they were no longer subject to a substantial risk of forfeiture, whichever occurred earlier. If the company were to go public or the employee were to sell the shares for cash during the seven-year period, taxes would have to be paid at the time of the liquidity event. The deferral election could also be revoked by the employee at any time, triggering taxes at that point.

Details Still Need To Be Worked Out

Open issues remain. A few questions that occurred to us:

• How, exactly, would these grants be structured?
• Why is the deferral for seven years?
• What information would be required in the election, and how would it be filed?
• How would this deferral election apply to early-exercise stock options that result in restricted stock which must then vest?
• Would Social Security and Medicare taxes be deferrable as well as income tax?

Nevertheless, this bill is a good way to start a discussion about changing the tax treatment of stock options and restricted stock units in startups and other pre-IPO companies. The approach of this legislation is more understandable than that of the Expanding Employee Ownership Act of 2016, which recently proposed another new type of stock option (covered at the end of a recent commentary elsewhere on this blog).

Test Your Equity Comp Knowledge: New Quizzes Expand The Fun Interactive Content Of myStockOptions.com

Put your books away, class. Time for a pop quiz:

• Can you define a corporate change of control?
• In what ways can equity awards be handled in a corporate merger, acquisition, divestiture, or spinoff?
• How can a pre-IPO company create liquidity for its stock other than being acquired?
• Why do some privately held companies grant early-exercise stock options?
• How soon after an IPO can you sell company shares?
• What is a lockup, and how do the lockup requirements differ from those under Rule 144?

The current back-to-school climate makes this an appropriate time to announce two new quizzes at myStockOptions.com. Bringing our total number of quizzes to a dozen, the recent additions test your knowledge of equity compensation issues in M&A transactions and pre-IPO companies.

Our quizzes are free to all users of our website (companies can license and customize them for their stock plan participants). All 12 are available by links from our home page, and each quiz also appears on the landing page the relevant content section. The answer key of each quiz has links to relevant articles and/or FAQs, making the quizzes not just gateways to our award-winning content but also helpful learning tools in themselves—and much more fun than homework.

Our short quizzes are separate from our Learning Center, which has in-depth courses and exams offering continuing education credits for Certified Equity Professionals (CEPs) and Certified Financial Planners (CFP). Our quizzes are also part of our growing body of interactive and multimedia content, which includes podcasts and videos.

Here We Grow Again: myStockOptions.com Expertise Expands With New Articles On Diversification, IPOs, And Foreign-Asset Reporting For Employees With Equity Compensation

At myStockOptions.com, our array of award-winning articles on all aspects of equity compensation has grown. In recent weeks, we have welcomed new contributions from expert authors on three crucial topics.

Importance Of Diversification For Employees With Equity Awards And Company Stock

Through its author's personal example, a new article at myStockOptions.com presents the dangers of a concentrated stock position, discusses why diversification may be hard for employees with shares from equity compensation, and explores strategies for preserving your net worth. In Your Company Stock: The Importance Of Diversification, CFP Laura Tanner recounts her experience with stock compensation at a company where she used to work as a research scientist, and she explains the lessons she learned.

To read the article and find more insights into investment diversification for employees with stock options, restricted stock/RSUs, or ESPPs, see our section Financial Planning: Diversification.

Careful Planning For Pre-IPO Equity Comp When The Company Goes Public

Initial public offerings (IPOs) are on the rise. The high-profile IPOs of Facebook and Twitter are just two of many IPOs that have been launched over the past couple of years, including several in Silicon Valley. In the newest installment of our Stockbrokers' Secrets series, our pseudonymous financial advisor W.E.B. Bantling provides a pep talk about smart planning for pre-IPO stock options, restricted stock, or RSUs when the company goes public. At the time of the IPO, when the company finally pours long-awaited liquidity into those grants, planning considerations must be carefully weighed.

In the author's experience, clients at companies preparing for an IPO are often giddy with thoughts of the wealth and opportunities it will provide. Many of them have worked at these companies since the startup stage, and the IPO represents a long-awaited event that may be life-altering for both their company and them. However, the author always emphasizes five planning points that may help to manage employee expectations in an IPO situation. He shares some of this wisdom in the new article, Stockbrokers' Secrets: Financial Planning For Equity Compensation At IPO Companies, available in our section Pre-IPO: Going Public.

International Equity Awards And Company Stock: Tricky Rules Of IRS Reporting For Assets And Income In Foreign Financial Accounts

United States citizens and resident aliens are taxable on their worldwide income. The related IRS reporting rules are complicated, and mistakes can lead to costly penalties. In fact, the IRS has launched an aggressive initiative to identify taxpayers with unreported foreign income and/or assets in foreign financial institutions. Charges of tax evasion stemming from unreported foreign income have been brought against dozens of individual taxpayers, including bankers, lawyers, and advisors.

In a new article at myStockOptions.com, compensation and tax expert Richard Friedman presents the rules and related issues of IRS reporting for assets and income that an international US taxpayer may hold in a foreign financial account—including those acquired through stock options, restricted stock, RSUs, or other equity awards. The article, International Equity Awards And Company Stock: The Confusing World Of IRS Reporting For Overseas Assets And Income, is available in our section Financial Planning: High Net Worth.

License Our Expertise For Your Employees

For companies, education is vital for ensuring that stock compensation motivates and retains highly valued employees and executives. All of our expert yet reader-friendly articles, FAQs, and other content are available for licensing by companies that want to improve their stock plan education and communications for participants. Content licensing is just part of the suite of corporate services that we offer.

Stock Compensation At Twitter: IPO Registration Statement Reveals Twitter's Extensive Use Of Restricted Stock Units

When a high-profile company prepares for an initial public offering (IPO), its SEC filings provide an opportunity to analyze the company's stock compensation practices. The IPO of Twitter—about as high-profile as you can get—is expected to occur by mid-November. Twitter's Form S-1 (Amendment No. 1, filed on Oct. 15, 2013) discloses its extensive use of restricted stock units over stock options (see the table on page 88). Apart from awarding stock options to its senior executives (see page 128) and using options in relation to acquisitions (see pages 136–138), Twitter seems to exclusively grant RSUs.

RSU Grants At Twitter

Under Twitter's 2007 equity incentive plan, RSUs granted to domestic employees before Feb. 2013, and all RSUs granted to international employees (the pre-2013 RSUs), vest upon the satisfaction of both a time-based service condition (mainly four years) and what Twitter considers a "performance condition," which is actually more like a vesting condition based on a liquidity event for the company. The performance condition is satisfied on the earlier of either (1) the date that is (a) six months after the effective date of this offering or (b) Mar. 8 of the calendar year after the effective date of the offering (which the company may elect to accelerate to Feb. 15), whichever comes first; and (2) the date of a change in control. (Details about the company's prior RSU grants appear in a letter Twitter submitted to the SEC in September 2011 to request a Section 12(g) exemption from registering its RSU plan under the Securities Act of 1934.)

While the vesting of these RSUs will cause dilution (see page 47), the amount of dilution will be is much less than it would have been with stock options. (Grants of options have to be much larger to deliver the same compensation grant-date value as RSUs.) The vesting of the post-2013 RSUs is not subject to a performance condition. Instead, the grants have just the standard time-based vesting over a period of four years (see page 86). For future grants after the IPO, Twitter is adopting a stock plan for 2013 that will be effective on the business day immediately before the effective date of the registration statement; it will then no longer make grants under its 2007 plan (see pages 130–132). Twitter is also planning to roll out an ESPP with appealing features (see pages 133–134).

Earnings Charge For Stock Grants

As of Sept. 30, 2013, no stock-based compensation expense had been recognized for the pre-2013 RSUs because a qualifying event meeting the performance condition was not probable (i.e. the grants had not fully vested). In the quarter during which the offering is completed, Twitter will begin recording a stock-based compensation expense based on the grant-date fair value of the pre-2013 RSUs. If this offering had been completed on September 30, 2013, the company would have recorded $385.2 million of cumulative stock-based compensation expense related to the pre-2013 RSUs on that date; and an additional $199.6 million of unrecognized stock-based compensation expense related to the pre-2013 RSUs would have been recognized over a weighted-average period of about three years. In addition to the stock-based compensation expense associated with the pre-2013 RSUs, as of Sept. 30, 2013, the company had an unrecognized stock-based compensation expense of approximately $698.3 million related to other outstanding equity awards (see pages 24 and 86–87).

See myStockOptions.com for additional information on restricted stock units, pre-IPO stock grants, and the rules on the timing of employee stock sales after the IPO.

Facebook Stock Comp: A Status Update

Earlier this year, we blogged about the potential stock comp wealth (and related tax issues) that seemed certain to blossom for Facebook employees amid the company's much-hyped initial public offering in May. Time and the market have popped these balloons of expectation. Although investors were predicted to "like" Facebook stock in huge numbers, skepticism about the company's valuation and prospects has prompted significant investor flight over the past few weeks. The surprising plunge in the stock price has created unexpected difficulties for the company's equity compensation.

Angst among Facebook employees about their equity awards has been widely reported (e.g. by Reuters and Business Insider). While the expiration date of the lockup on most employee shares (almost 50% of total shares outstanding) is still fairly far off (Nov. 14), Reuters notes that some employees are already adjusting their expectations because of the poor post-IPO performance. Many now plan to sell a smaller portion of their stake in the company than they otherwise would have if the stock price had risen or even just stayed flat. "I will definitely take some," said an employee anonymously quoted in the news report. "But my debate is how much." The article in Business Insider wonders whether Facebook may develop problems with employee retention, at least in the short term.

Additionally, Facebook needs to raise cash for the taxes ($2.5–4 billion) incurred by its share withholding at RSU vesting, and it has been planning to sell shares to cover this. Because of the fallen stock price, financing that tax bill will now be more difficult than expected.

Facebook employees who joined the company during the past 18 months (perhaps half its workforce) were granted restricted stock units (RSUs). This is fortunate for them. Unless the underlying stock price drops to zero, RSUs always have some value. Stock options, by contrast, would be well underwater, as the exercise price would reflect the pre-IPO stock valuation—much higher than the current depressed price. Before the IPO, various option-valuation models gave Facebook stock a worth of $24.10 during the first quarter of 2011 and around $31 in the first quarter of 2012. Now that the stock price is below these thresholds, the golden handcuff would have lost its lure for restless employees.

In this blog we have also discussed Zynga's pre-IPO demand for nonproductive employees to give back large unvested stock grants. Bloomberg has revealed that Zynga is now broadly granting stock options to retain staff after a fall in the company's stock price. Like Facebook, Zynga had previously granted mostly RSUs. The reasoning behind the switch seems clear. Stock options have much more upside than restricted stock. In short, you get more options per grant, and the fixed purchase (exercise) price provides investment leverage. As a result, options have the power to generate much greater wealth from stock-price appreciation than restricted stock/RSUs do. This, in turn, may help to keep employees at the company.

If Facebook believes its stock is unreasonably depressed, we wonder whether it too will start proffering the golden carrot of stock options to motivate and retain employees. This move could also signal some much-needed optimism about Facebook stock. If or when the stock price does rise, these options would be much more valuable and attractive than RSU grants.

Million-Dollar Question: A Week After The IPO, What's The Latest On Facebook's Stock Comp?

It's been one week since Facebook's initial public offering. Last month, this blog provided various insights into the company's stock grants and the related tax issues for Facebook employees.

As we mentioned then, and as Facebook's registration statement (page 48) explains, the restricted stock units granted by the company before 2011 will not pay out and fully vest until six months after the IPO. They face two vesting hurdles: time worked at company and a liquidity event (i.e. the IPO). We have seen these types of vesting requirements in grants made by some other pre-IPO companies, such as Twitter (see an FAQ at myStockOptions.com).

Facebook continues to rely on the broad use of RSU grants, though these will vest in the standard time-based way. In the 6th amendment to its S-1 registration statement, the company disclosed that in early May it awarded more than 25 million RSUs in what it termed "employee refresher grants" (see page 78 of the S-1 and an article at the blog TechCrunch).

Now for the million-dollar question (literally). How much wealth has the IPO created for employees at Facebook? How many are now millionaires? According to Aaron Boyd, Director of Research at the compensation research firm Equilar, at the time of the IPO the average paper value of equity per employee was $4.9 million (excluding CEO Mark Zuckerberg's vast holdings). Equilar used the information in the prospectus for the most recently completed quarter for the number of options and restricted stock outstanding as of March 31, 2012, and calculated the values with the IPO price. In an article on May 21, The Washington Post reported that 600 of Facebook's 3,700 employees and 250 former employees will become millionaires, according to PrivCo, a research firm.

The wealth created for senior executives will be much greater. An insider of a company registering stock for the first time under Section 12 of the Securities Exchange Act must file Form 3 under the SEC's Section 16 rules no later than the effective date of the registration statement. It's worth looking at the data in these fillings by Facebook insiders for the stock grants and outright stock holdings and how they are reported with the SEC on Form 3.

For example, the Form 3 for CFO David Ebersman shows he holds 1.2 million RSUs that vest quarterly between early 2012 and early 2019, along with options to buy 4.5 million shares at $3.23 per share. These began vesting in 2010, starting with a fifth of the grant, followed by monthly tranches that will bring the grant to full vesting by 2015. In a footnote, the Form 3 also discloses that the RSUs he holds in which vesting is based on both continued service and liquidity (additional 6.75 million RSUs) are not considered reportable under SEC rules. The Form 3 for COO Sheryl Sandberg also contains new details on her options and RSU grants, such as the vesting provisions. Mark Zuckerberg's Form 3 discloses his stock options, along with the company stock he owns through various trusts (an estate-planning technique to minimize taxes).

When these executives and other senior executives at Facebook get more stock grants or sell company stock, they will have to make filings on Form 4. In addition, sales will also need to follow the SEC's Rule 144 requirements. These will be worth following, as they may reveal some information about individual financial planning, such as whether sales are made under Rule 10b5-1 trading plans, along with showing any changes in Facebook's stock compensation practices after the IPO.

[For more on Facebook stock compensation, see our blog entry of October 29 about the end of the lockup.]