In the past twelve months I’ve been fortunate enough to learn a lot about how an IPO (Initial Public Offering) impacts employee stock options. I was previously an early stage employee at two companies (Zillow & Yelp) that reached their IPO milestones.

Abraham Lincoln once said:

I don’t think much of a man who is not wiser today than he was yesterday

Since I agree with his sentiment I wanted to share some of the knowledge I learned from the IPO processes. This post won’t discuss the IPO process itself but will simply try to convey my learnings from the IPOs and how they impact common stock and employee stock options.

I’ll assume that you have a working knowledge of how employee stock options work but if you need a refresher it might be worth reading my “Common Stock Option Mistakes” post before continuing.

I feel all posts that involve financial topics should come with the disclosure that a financial professional (I am not one) should be consulted before making complex financial decisions.

Reverse Splits

A reverse split can also be called a stock merge and is well defined here. In short, it’s basically where a certain number of shares are combined into a single share of higher value. For example, let’s imagine you own 10 shares valued at $1 each, a 10 to 1 reverse split would result in you owning 1 share but valued at $10. There is no change in how much your stock is worth. An x to 1 reverse split is somewhat common prior to an IPO since it can result in a more attractive price for a single share (see this article for more details on pricing strategies). Reverse splits make it even more important to understand what percentage of the company your stock options entitle you to. Please ignore the number of shares or stock options you have since that number can change at any time, it’s all about the percentage.

The Lockout

Prior to the IPO you will most likely have agreed to a “Lockout Period”, which prevents insiders from selling their stock for x number of days after the IPO. In most cases this lockout period will last 180 days but it varies (Zillow for example allowed a certain portion of shares to be sold earlier if specific price targets were reached).

The Transfer Agent

It is likely (drawing from my own IPO experiences) that the company will enlist the services of a “Transfer Agent” to handle the distribution of shares following the lockout period. You can expect communications from this transfer agent shortly after the IPO, at which point you’ll likely get access to an account summary (how many shares you own etc.). The transfer agent will be able to facilitate a sale the day the lockout ends or be able to transfer your shares to a regular brokerage account (e.g. eTrade etc.).

Leaving Company Prior to Lockout Ending

If you have unexercised stock options and are considering leaving a company while a lockout period is in place you’ll want to think through some scenarios. Your tax implications can be radically different depending on when/if you decide to exercise your options.

  • You’ll likely have 90 days from your date of departure to exercise your vested options. Once you exercise your stock options you may be on the hook for some tax obligations. For example, if your strike price is $1 and the current market value of a share is $100, you may be on the hook to pay tax on the $99 unrealized gain.

  • Since stock markets can be volatile it is possible that the stock price will have dropped dramatically by the time you can sell the shares. To continue from the above example, let’s say the stock price drops to $5, since you exercised at the $100 price. You may still be on the hook for the unrealized gain of $99 even though you can only sell the shares at the $5 price.

Closing Thought

The worst case scenario is that you exercise stock when the current market value is much higher than the market value when you can eventually sell the shares. I personally prefer the idea of covering any tax liability using “house money” (money from the sale of said shares). Obviously this is a personal decision and there are numerous factors to consider, least of which being where you expect the stock price to go in the future.

During the original dot-com boom some people got themselves into trouble by exercising stock when the stock price was inflated and they never got the opportunity to sell any stock at the inflated price due to the market turning against them. For example, Excite@Home’s stock went from trading for $99 to trading for pennies (full story here). Obviously Excite@Home is an extreme example but it’s one of the situations where preparing for the worst and hoping for the best makes sense.