Get a jump on your New Year’s resolution to exercise ???

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Hey everyone,

Chris Arnold, CFP? here. I’m the Lead Financial Planner at Secfi , working closely with Vieje Piauwasdy and John Morrison, CFA .?

As I continue to meet with startup employees, I've definitely noticed a shift in sentiment over the past few months.??

At the start of this year, many were eager to exercise their options ahead of their company's imminent IPO.?

Nowadays, more conversations start with "My company isn't going to exit any time soon and what happens to my equity if I'm laid off or want to pursue another opportunity before then?"

There's no doubt that 2022 has been a challenging year for startups across the board. Still, I do believe the current moment provides opportunities for startup employees to position themselves in a favorable situation when the IPO market and venture funding bounces back.

With that, I wanted to share some thoughts on what you can do with your stock options before we head into 2023.?

We’re going to be sharing more year-end tax strategies for the next few weeks. Let us know if you have any specific questions (yes, we’ll touch on crypto tax-loss harvesting, and more).?

If you have any specific questions about your situation, feel free to reach out.

?? It’s not too long ago that IPOs were hot — like really hot.?

2021 was the biggest year ever for IPOs in the U.S. Everyone who worked at high-growth, private tech companies believed they were on the fast track to a financial windfall.?

So, it’s not surprising that many individuals thought surely their company would IPO by the end of 2022, and they could “cash out” on their highly-appreciated equity.?

But, oh how things have changed.

?? 2022 turned off the heat, creating one of the quietest IPO years on record.?

The rush to go public has disappeared — though there are rumblings that it could start coming back to life in 2023 — and so has employees’ enthusiasm about their equity.?

But, it’s not all doom and gloom for tech employees. And, actually, this lull offers some silver linings. In fact, right now could be a good time to take action on your stock options

?? Valuations at public tech companies have been cut by 50 to 80% this year, and it’s trickling down to private companies.?

I won’t go into the “why”, though my colleague John touched on it last week: profitability trumps high-growth during volatile times.

But, the fall in valuations is affecting private companies and many companies have lowered their 409A, or the Fair Market Value (FMV) of their stock.

?? Wait…isn’t that a bad thing for me, and my company??

Not necessarily.

?A recent report from Pitchbook notes that only 13% of companies that raised down rounds between 2008 and 2014 struggled to raise more money or find an exit.

But, let’s just assume that your company is still poised for an exit — maybe just not as soon as you assumed, or hoped.

?? With that in mind, let’s see what these valuation cuts mean for you.

First, a quick refresher on how stock options work.

Let’s say you were granted 20,000 incentive stock options (ISOs) at a strike price of $0.50. This means that you have the option to purchase shares of your company stock for $10,000 (20,000 * $0.50).?

Now, you’ve already been with the company for five years — so you’ve vested all your granted options — and you’ve seen it grow significantly.?

At the beginning of this year, the 409A had grown to $30 a share from the $0.50 when you joined. If you had exercised all of your stock options then, you would still pay $10K, because your strike price never changes.

BUT, you do have to pay tax on the spread between your strike price and the current 409A valuation, which would’ve been $29.50: 20,000 * $29.50 = $590,000.?

The IRS considers the discounted price you’re getting for these shares — the $0.50 cost per share — compared to the current FMV as the “bargain element” (or phantom income).?

Basically, they say that those shares have increased in value (despite it all being on paper) and, therefore, they want to collect tax revenue on it in the form of the alternative minimum tax (AMT).

You can see how suddenly a $10K cost (which is still a lot of money) can quickly balloon when you also owe tax on a nearly $600K gain.?

BTW, the exact amount of taxes depends on your personal specifics, like income, state of residence, etc.

??You might already see how a valuation cut can be beneficial.?

But let’s break it down.

Now, let’s imagine that the current market conditions have caused your company to recently update their 409A to $18.?

Now, if you go to exercise all of your vested options, your “bargain element” would only be $17.50, reducing your ISO gains to $350,000.?

Assuming you have a Federal AMT tax rate of 28%, this could reduce your AMT bill by $67,200!

??So…you’re saying I should exercise??

Now, just because the cost to exercise has decreased doesn’t necessarily mean you should pull the trigger.?

It’s just another factor that you should consider when deciding to exercise. My point is to show you that what could be interpreted as a negative — valuation decrease, an exit delay — can actually create a potential opportunity.?

Of course, there are multiple key factors that you should also consider, starting with:

• Investment opportunity: Would you consider your company to be an attractive investment, if you were not an employee?
• Company health: Does your company have a sustainable business model? Has the company continued to increase revenue, attract more customers, and/or create new product lines over the past 12 months? (Again, a valuation decrease doesn’t necessarily indicate one or all of these aspects are not working, but could be more indicative of the broader market perception of valuations).
• How will you pay for it? Can you afford to pay the cost to exercise plus the taxes? Could you afford to exercise some of it? Would you need to look at financing or loan options to do so?
• Can you take the risk? Exercising stock options always carries various risks. But, in this case, would your life change significantly if you lost the money you spent to buy your shares?

Some answers may depend on where you are in your life and career. Do you have financial obligations, like paying a mortgage or paying for your kids’ college? Are you saving to buy a home? It’s important to put your exercise decision in the context of your other short-term and long-term financial obligations.?

You can also ask yourself about the other side: If this is an investment opportunity you’d want to take, would you regret not taking that? And how comfortable are you with the risk of not doing it?

??The biggest hurdle for exercising is usually the cost.?

In the above example, the cost to exercise, even after the valuation cut, can still be prohibitive for many. Even the $10K base cost could be too much.?

So, what can you do? Well, there are specific strategies you could take advantage of before the end of the year:

1. Exercise up to the AMT limit: If you have ISOs, you can likely exercise a portion without paying tax. You may not be aware, but you receive an AMT exemption every year you file (it’s why you probably don’t pay AMT most years, if you ever have). Since this is an annual exemption, it’s a “use it or lose it” thing. If the value of your options has appreciated since they were granted, this strategy could make sense to start the one-year holding period on shares for favorable tax rates when you’re able to sell.?
2. Use last year’s AMT Credit by exercising NSOs: It’s possible you may have both ISOs and NSOs, especially if you received an extended post-termination exercise window at a previous startup. If you do, and you exercised ISOs last year that triggered AMT, consider exercising NSOs and utilize the AMT credit you have to offset the taxes from the NSOs. This strategy could be attractive if your company has reduced its 409a value during the year.?
3. Spread a 90-day exercise window across two tax years: If you’ve left your job recently, it’s likely you only have 90 days to exercise your options. But, given it’s the end of the year, you can spread that 90 days across 2022 and 2023, allowing you to exercise up to the AMT limit for both tax years.
4. Make sure equity is part of your ongoing financial planning: If your company has delayed their IPO plans, you can use this additional time to get a plan in place for when it does happen. For example: which grants you should sell first, how much taxes you may owe, price targets you’d want to sell for, and a reinvestment strategy to continue growing your wealth. Excitement about an imminent exit, or feeling dejected about a delay can lead to suboptimal decisions about equity. The silver lining of the current circumstances are that investment risks are top of mind and this helps when developing a reasonable financial plan.

?? Bottom line: We make educated decisions based on the information we have at the present time.?

No one can reliably predict when the IPO market will come back. But by taking action today, you can position yourself for additional flexibility and to retain more upside if, and when, your company does exit.?

Things we’re digging:

• ?? Are the layoffs working? Last week, touched on an impetus for the unfortunate recent layoffs being due to inflation (and rising interest rates). Back-to-back inflation reports showed it cooling, so all eyes are on the employment report due early December.
• ?? “That loser Tolstoy.” It’s surprising many of us didn’t see SBF's red flags earlier.
• ?? For the greater good? I guess we’ll find out!