Many companies aiming to go public someday are offering equity to employees in the hopes that it might one day become worth a lot. A common way to do this is through Incentive Stock Options (ISOs). This article discusses an overview of this offering, some of its implications, and the risks to be aware of.
ISO Definition
Incentive Stock Options (ISOs) are the option, but not the obligation, to buy employer stock at a price lower than what is offered to outside investors, also known as the fair market value (FMV). Think: employee discount on stock. Hypothetically, you may get offered to purchase stock for $1 per share while the current FMV is $10 per share.
Important Dates to Keep in Mind
Since ISOs are not stocks but options to purchase stock at a discount, there are a few key dates to keep in mind:
1. Grant Date: This is the date that the company grants you the ISOs.
2. Vest Date: This is when you can use the stock grants, your first opportunity to sell. Many private companies have a 4-year vesting with a 1-year cliff. This means that 25% of the ISOs become available after a year with a small percentage becoming available monthly thereafter.
3. Exercise Date: This is when you choose to pay funds to purchase stock. If the option is for 1,000 units at $1 per share, you will pay $1,000.
4. Sale Date: This is when you sell the stock that you bought at a discount.
Opportunities for Sale
ISOs are offered at both publicly traded companies and private companies. If you are an employee at a publicly traded company, opportunities for sale are plentiful because you can sell to any person on the public stock exchange.
To liquidate the stock position of a private company, one of a few things needs to happen:
1. The private company goes public via an Initial Public Offering.
2. The private company is bought by a publicly traded company.
3. The private company offers to buy stocks back from investors.
4. The holder of the private stock finds a private investor.
If none of these events happen, you will be unable to liquidate or may have to consider negotiating a sale at a lower price than the fair market value. If the company goes under while you hold stocks, your investment has essentially gone to zero.
Tax Situations
I highly recommend that individuals considering exercising or selling ISOs work with a tax professional who has a wealth of experience with ISOs. There are several specialized tax situations that can arise and getting it wrong could have steep consequences.
The most tax favorable tax situation is known as a qualifying disposition. In a qualifying disposition, you opt to buy the stock at least one year after the ISO is granted and sell the stock at least one year after exercise. Unless you are subject to AMT taxes, the difference between what you paid for the stock and what you sold it to will be subject to long term capital gains, which tends to be the lowest amount of taxes one can pay on a gain. Again, you will want to work closely with your own qualified tax professional with regard to your particular circumstances before taking any action.
Any situation that is not considered a qualifying disposition is referred to as a disqualifying disposition. Depending on when the exercise and sale happen, an individual entering a disqualifying disposition can face any cocktail of taxes including income taxes, short term capital gains, long term capital gains, and/or AMT.
Risks And Advice
There are a lot of unique risks associated with exercising ISOs.
As discussed previously, ISOs for private stock come with liquidity risk. There is a chance that a liquidity event never happens and you either must sell for less than you’d like, or the company goes under, and the stock is worth nothing.
All concentrated stock positions also come with diversification risks. Generally, the reason that many people invest in broadly diversified portfolios is because the movement of any one stock can be extremely volatile and unpredictable. While buying a stock for basically nothing and selling it when the stock price is very high in a few years is an ideal situation, individual stocks do not always work that way. Of course, even diversification does not guarantee a profit or protection against loss in a declining market.
And contrary to popular belief, individual stocks don’t have to come back up like the overall market after a significant dip.
People who have been granted ISOs at privately held companies, haven’t exercised the grants, and do not have a surplus of excess fun money should seek the guidance of financial professionals in determining if exercising their options might be appropriate and suitable for them.
Conclusion
ISOs can be an exciting incentive for employees to work hard to grow the company they work for into a successful one. However, ISOs can come with some complications, including fronting funds, tax consequences, concentration risks, and liquidity risks. If you are considering participating, it is important to speak with a qualified tax professional about the tax consequences and a financial professional to see how they can support your overall goals.
This informational and educational article does not offer or constitute, and should not be relied upon, as financial, investment, or tax advice. Your unique needs, goals, and circumstances require the individualized attention of your own tax and financial professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, approve or make any representations as to the accuracy, completeness, or appropriateness of any part of any content linked to from this article.
Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-5795051.1(07/23)(exp.07/25)
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