Will an IPO prove to be a transformative event for employees of that company? The answer to that question can be: Yes, No, or Maybe. In other words, it depends.
Depends on what? Well, there can be any number of possible factors in play on this point – who has stock options and on what terms, who has been awarded restricted stock units (RSUs), what restrictions are in place on selling your stock after an IPO, how stock options are taxed, and, lest we forget, how those shares perform on the public market upon flotation.
Employees will be focused on all these points and others, so the more clarity a company can offer, and as early as possible, the better. As with so many aspects of business life, communication is king, and, in this scenario, can help to reduce some of the anxiety associated with going public and help to steer minds towards the positive possibilities associated with going public.
Record amount of IPOs
While no one can know for sure how an IPO will play out, one thing is clear – private companies have rarely been more interested in going public. Last year saw 480 IPOs on the US stock market, more than double the figure recorded for 2019 and the biggest number is seen since 2000. This year, we will see another noteworthy benchmark set, with 464 IPOs already recorded by early May, suggesting the 2020 total will be surpassed long before the halfway point of 2021.
Whatever about what the future holds, for now, IPOs are clearly having a “moment”, and employees with stock options or RSUs at a company embarking on that journey are entitled to wonder what it will mean for them.
Early-stage employees and executives with stock options may be best placed to experience a financial windfall arising from going public. Stock options at an early-stage startup will invariably be granted on favourable terms to employees. In the early days of a company’s life, it will need to attract the level of talent it needs to get off the ground but will be unable to compete with more established competitors on salary. One of the ways around this is to offer stock options on generous terms, with a view towards those options being worth more – possibly far more – than the agreed strike price in the future.
The potential of early options
Even an IPO that was perceived to have gone badly can still significantly benefit the employees
Going public can be an exciting time for employees in this position. Even if the flotation doesn’t go as well as hoped, these individuals can still win big, as part of the attraction of early options is that they will often be granted at a very low price.
Consider the following scenario:
# An employee is granted 100,000 options at an early-stage startup at a strike price of €1 per share.
# It will cost the employee €100,000 to exercise all options.
# At some point in the future, the company announces an IPO, with the initial share price fixed at €20.
# Each share the employee can buy or has bought for €1 will be valued at €20 in the initial floatation, so the options that cost €100,000 would be worth €2,000,000 on floatation day.
# This means that if you were that employee you would be looking at potential pre-tax proceeds of €1,900,000 arising from exercising and then selling your shares.
There are caveats that could be attached to this scenario – for example, on post-floatation lockup periods and potential tax liabilities – but the implications are clear. Even if the share price moves in the wrong direction once publicly traded, these hypothetical early employees will be poised to do well, barring a full-on collapse in price. On the other hand, if the floatation proved successful and the share price increased, by the time any lockup period expired, they would be poised to profit even more, easily becoming millionaires if they chose to sell at the first opportunity.
RSUs – more reason for optimism
The scenario for those who have been awarded RSUs (Restricted Stock Units) tends to be a little different, but they too can feel optimistic. RSUs differ from options in the sense that they are an award of actual shares (or cash, but usually shares) that vest either upon the achievement of specified performance goals or after a set period of time. You can choose the point when you exercise options or even let them expire, but RSUs will always vest upon the achievement of the relevant milestone.
Another clear point of difference is that while an option can be exercised for a pre-determined price, RSUs are pegged to the company’s current share value, which in the context of an IPO may turn out to be positive or negative.
So, depending upon the value of the company’s shares at the point of vesting, an employee with RSUs will feel either relatively pleased or disappointed. However, “relatively” is the keyword here, as an RSU is always worth something, which, in theory, is an advantage over options. If the market price is below the strike price, then an option is basically worthless, but, particularly in the context of early startups, the strike price will be set so low as to make this eventuality highly unlikely. The same may not be true for options granted closer to the IPO, as the valuation at that time will be closer to the target IPO price, which may or may not prove to be over-optimistic.
Employees also need to be aware that options and RSUs will be treated differently for taxation purposes. Incentive stock options receive favourable capital gains tax (CGT) treatment if held for two years after being granted and then an additional one year upon being exercised, whereas non-qualified stock options will be liable for income tax at exercise and subject to CGT on whatever gain may accrue upon being sold. RSUs are also subject to income tax upon vesting but will not be liable for CGT if disposed of on that date.
There is always a risk as well as reward
There is risk attached to this entire area, and your employees need to understand that. There are no guarantees that a strategy on how and when to exercise stock options will work out exactly as intended. With RSUs, decisions on when to exercise are taken out of the hands of the employee, but they are then still left with the potential dilemma of deciding when or if to sell their shares after going public. Once the lockup period expires, all shareholders are left facing this quandary. The typical challenge is to grapple with the desire to turn paper profits into realised gains or to commit for the long haul, in anticipation of greater gains down the line.
These decisions should not be taken lightly and not all employees will possess the necessary knowledge and expertise to make the right calls. This goes back to the point made earlier on communication. Ultimately, your employees will make their own decisions, but an information drive during the IPO process would help to alert them to the key considerations and pitfalls.