When Tech Deals Go Well - Maximizing ISOs

The Importance of Planning with Incentive Stock Options

We often witness the profound impact that careful financial planning, especially when it involves equity compensation, can have on clients’ lives. One particular success story highlights the importance of managing Incentive Stock Options (ISOs) effectively.

Establishing your financial plan

A few years back, a client approached us. Let’s call him “Michael” to protect his identity. Although he was earning a good salary at his company, a substantial portion of his compensation was in the form of ISOs. Michael sought our help to understand how a successful company liquidity event could help him achieve his family’s financial goals.

We began by sitting down with him and his spouse to talk about their plans for the future. They both wanted to retire at 65 while maintaining their current lifestyle. They also needed to save for their tow children’s college education and set up trusts to ensure their kids had a strong financial start.

With this vision in mind, we embarked on a comprehensive financial planning project that considered various outcomes for the future success of Michael’s company.

Understanding Incentive Stock Options (ISOs)

Incentive Stock Options are a type of employee stock option that can only be offered to employees (not board members or contractors) and come with favorable tax treatment if certain holding period requirements after grant and exercise are met. Here are some key points about ISOs:

• Eligibility and Grant: Only employees can receive ISOs and the grant must be part of a formal plan approved by shareholders. Additionally, there is a $100,000 limit on ISOs per employer per year.
• Exercise Price: The exercise price must be at least the fair market value of the stock at the time of the grant.
• Holding Period: To benefit from favorable tax treatment, the shares must be held for at least one year from the exercise date and two years from the grant date.
• Tax Treatment: Understanding your tax liability is crucial in financial planning. You will owe taxes on your ISOs only when you exercise them. And if the holding period requirements are met, gains upon sale of the stock are taxed as long-term capital gains rather than ordinary income. However, there is a risk of the Alternative Minimum Tax (AMT) with ISOs. If you exercise and do not sell in the same year, there is a chance of AMT.

Your financial planner or tax advisor can help you determine the ideal time to exercise your options and sell your shares.

The uncertainty of stock options

ISOs present planning challenges. The company could be performing well today but the options could be worth nothing when it’s time to exercise them. However, Michael believed in his company’s potential for a major liquidity event soon.

We considered scenarios where ISOs might be worth anywhere from $0 to the company’s current valuation and we projected his spending through age 95.

By running thorough calculations, we helped Michael explore various strategies, such as early exercise of his options and potentially selling some shares on the secondary market before a liquidity event. We also developed a diversified investment plan for his other assets based on the risk he needed to assume to maximize his goals. Additionally, we set up an estate plan for tax management and ensured both his and his wife’s wishes were recorded in a living trust.

Navigating the IPO and acquisition

As life is dynamic, financial circumstances can change. Two years later, Michael’s company filed for an initial public offering (IPO), putting a new value on the shares. However, Michael was subject to a 180-day lock-up period, typical for IPOs. After this period, he could only sell shares within the company’s stipulated open-window periods.

Michael chose to sell some shares back to the company at the current private valuation to gain certainty and control over his financial future, rather than leaving it up to the stock market’s. Historical examples, like Facebook’s shares falling after its 2012 IPO and taking over a year to recover, according to Kiplinger, or Twitter’s shares selling around 40% below its IPO price four years later, illustrate the market’s unpredictability.

Selling a portion of Michael’s vested shares allowed us to allocate the proceeds towards achieving his outlined financial goals.

Before the IPO, Michael’s company was acquired by a Fortune 500 technology company. As part of the deal, Michael received a combination of cash and stock in the acquiring company.

After reviewing the acquisition terms and updating his financial plan, we were able to deliver the great news to his family.

Peace of mind

While some of Michael’s colleagues were scrambling to understand the tax implications of the acquisition, he had peace of mind. His comprehensive financial plan covered all aspects, ensuring he knew what his financial future held as soon as the deal closed.

By understanding the complexities and potential of ISOs, you can make informed decisions that align with your long-term financial goals. Proper planning and professional advice are key to navigating the uncertainties and maximizing the benefits of incentive stock options. Talk with one of our wealth managers to see how you can maximize your ISOs.