An Employee's Guide to Pre-IPO Liquidity Access

The world of liquidity has shifted for employees and founders of pre-IPO companies throughout the innovation sector during the last 10 years. Gone are the days of waiting for your company to go public before being able to access liquidity.

Today, most companies that make it past a Series B funding round contemplate whether to give employees access to liquidity. This is a complex issue that requires deep expertise to arrive at the most equitable decision. Here are a few scenarios to help you understand the complexities involved.

Case study: Ella the cofounder

Ella is a cofounder of an enterprise software company who has successfully raised a Series A funding round and is thinking of raising a B round. Her cofounder wants to sell some shares to make a down payment for a home in the San Francisco Bay Area and would like to approach company investors to discuss the liquidity options available for them both.

While she wants to support her cofounder, Ella doesn't need the cash now and believes in the upside of her equity. She's not sure if she wants to sell shares during this fundraising round. Ella should consider several factors when making this decision.

The mechanics of balancing risk and reward

The top issue involves risk and reward. Companies at this stage are highly risky, and common stock is riskier than the preferred shares held by investors. According to Dealroom.co, the odds of reaching the next fundraising round after Series A are about 50%. Therefore, Ella's primary concern should be accepting that the odds of reaching the exit she envisions are low and taking some chips off the table may be a prudent decision.

Ella's next step should be choosing how many shares to sell. Her cofounder has a clear number in mind because he needs a down payment plus $100,000 for various living needs. Once he knows his share price and the associated tax consequences, he can back into the correct number of shares he should sell.

Ella should consider a few things. Founders are typically focused on keeping as much ownership as possible so they can continue to have a say in their business. They strongly believe their company will enjoy long-term success and tend to believe they'll beat the odds. They rarely spend time thinking about whether the difference in selling some shares today or holding all shares to the exit will significantly improve their life when that time comes.

If we assume Ella owns 25% of the company and the valuation at the last round was $50 million, her ownership is worth $12.5 million today. If she assumes the company will have a successful outcome of $500 million in the future—and her diluted ownership at that future date is worth 7%—her stock would be worth $35 million.

If she sold 10% of her ownership today at $1 million, assuming a discount from the valuation paid in the B round, she'd still end up having $31.5 million on the exit.

Here are some questions Ella should ask herself.

• Would receiving a pretax amount of $35 million versus $31.5 million significantly impact her life when—or if—the company exits?
• How much better off would she be, having taken $1 million off the table now, if the company never gets an exit?
• How much growth could she receive on money she gets from selling some shares today?
• How much stress will taking $1 million off the table today generate over the next few years?

Focusing on these questions can help Ella understand the elements involved when selling shares at the same time as her cofounder.

Case study: Zeb the early employee

Zeb is an early employee of an AI company. When he started, he was given an incentive stock option, or ISO, of 300,000 shares with a strike price of $0.05 per share. He exercised half of the shares before the company raised their A round 4 years ago and received another grant of ISOs of 100,000 shares with a grant price of $0.25 that is half-vested.

The company is raising a C round this month, and as part of the raise, they're allowing employees who've been with the firm more than 5 years to participate in a partial liquidity event. The company believes the sale price will be $3.50 per share.

Understanding the nuances of employee liquidity

Zeb wants to renovate his house, so he decides to participate in the C round liquidity event. However, he's unsure how to determine the amount to sell and whether to sell the shares he purchased or use some of his ISOs to initiate a same-day sale. His early grant has 3 more years before it expires.

Zeb should ask himself the following questions as he considers these options.

• Should he exercise the remaining 150,000 options from his first grant before they expire in 3 years?
• If so, what are the tax consequences in addition to the $7,500 it will cost to exercise?
• Does it make sense to exercise all his vested shares to get the long-term capital gains clock ticking?
• How much longer until a full liquidity event?
• Does he intend to stay with the company until it has a full liquidity event? If not, he should plan to exercise shares prior to his departure.
• What are the tax ramifications of selling his purchased shares versus a same-day sale with his ISO shares?

The key for Zeb is understanding current and future tax implications and assigning a probability to the successful exit for the firm. Of primary importance will be the determination of whether the 150,000 shares he exercised 4 years ago are eligible for qualified small business stock, or QSBS, treatment if he holds them for an additional year.

If the answer is yes, his tax savings could be more than $123,000 based on the current value of the firm. He should understand that each time he exercises his options, he may have an alternative minimum tax, or AMT, consequence the following April when he files his taxes. Delaying the exercise could increase this risk, and he should work closely with his CPA when making this decision.

Liquidity event education for employees

In a recent virtual webinar, Ann Lucchesi, senior director with First Citizens Wealth, led a discussion regarding liquidity options for pre-IPO company founders, investors and employees. In the excerpt below, she asks panelist Emma Mann-Meginniss, a partner with Cooley, how important employee education is during a liquidity event.

Examining two paths to liquidity

Essentially, if Zeb wants to exercise his remaining options to start the long-term gains clock ticking, this may be a good time to sell shares to generate the necessary cash to both exercise all his ISO shares and fund his home renovation.

Initiating a same-day sale will create ordinary income that's taxable at higher rates than using his shares, which have long-term capital gains treatment but aren't yet qualified for QSBS. This means selling more shares via a cashless transaction to create enough funds for exercising and remodeling.

Assuming Zeb lives in a state without income tax and sells 25,000 shares at $3.50 with the top capital gains rates, he would earn approximately $66,675. This would leave him with money for the renovation, as well as the option exercises. However, he'll give up some future tax savings by selling shares that could have been eligible for QSBS.

On the other hand, if he did a same-day sale of 25,000 of his early options—assuming he is in the 32% tax bracket—he'd have approximately $59,500 to use. He'd reduce his risk but end up with less cash to use.

To make the most beneficial decisions, Zeb should consult a tax advisor who can explain the tax issues, help him determine the most important factors and provide strategies that account for his assumptions.

Case study: Beth the engineer

Beth is an engineer at a pre-IPO company. She has been with the firm for 9 years and has the following grants:

• 100,000 options—ISOs—at $0.75 per share issued 9 years ago, fully vested
• 40,000 options—ISOs—with a grant price of $1.50 per share issued 6 years ago, fully vested
• 40,000 shares of nonqualified stock options, or NSOs, with a grant price of $2.50 per share issued 4 years ago, fully vested
• Restricted stock unit, or RSU, grants for 10,000, three-quarter vested with a second liquidity trigger in addition to the time-based vesting
• RSU grants for 10,000, one-quarter vested with a liquidity trigger in addition to the time-based vesting

The company's current 409A valuation is at $22.50. They thought they'd be public earlier this year, but it looks like the IPO is at least a year away.

Beth is concerned because her initial grant will expire in a year. She's risk averse and thought she could wait until they went public before exercising the option. Now she isn't so sure, and she doesn't have the cash to exercise the option.

The company is making a tender offer for shares at $25 per share, and each employee can sell up to 25% of their vested holdings. While the RSUs may be used to determine the 25%, they can't be used to sell. Beth isn't sure how many shares to use—and which ones.

Asking a few key questions could help Beth make a decision.

• How much money will she need to exercise her initial grant?
• Should she exercise her other options?
• How many shares is she allowed to sell?
• How much should she sell?
• Is she planning on staying with the company after the public offering?

Preparing for employee liquidity events

During this portion of the webinar, Lucchesi asks Mann-Meginniss for insights regarding the timing of pre-IPO liquidity events for employees.

Determining the true cost to access liquidity

A starting point for Beth is understanding the minimum amount she'll need to pay for exercising her first grant. The cost is $75,000, but the implied gain of $2,175,000 will create a situation where the AMT kicks in. She can spread the exercise over 2 taxable years, but that's still over $1 million as an add-back item for AMT. If she assumes she'll pay the maximum amount, she should be prepared for $609,000 in AMT at the federal level.

Assuming no impact on her state taxes, she'll have to raise $684,000 just to exercise her initial grant. Because she has no shares to sell, she'll need to do a same-day-sale. However, if she completes a same-day sale, she'll need less money to finish exercising the remainder of the shares.

First, she may want to know the maximum amount she can sell. All of her grants are vested—180,000 shares—and 10,000 of her RSUs are vested. This means she can sell up to 47,500 shares. Because she's risk averse and worried about the initial grant, let's assume she sells all 47,500 of them in a same-day sale. Can she exercise the remaining 52,500?

If we assume she's paying about 37% in taxes on the sale, she'd be left with $748,125. The cost of exercising the shares is $40,125 and the maximum federal AMT obligation—based on the $25 value—is $356,478 based on 28%. It also leaves her enough to consider exercising the ISO for 40,000 shares over the next few years.

Beth should bring in an accountant to confirm her actual tax numbers, but a tax advisor using conservative estimates can help her decide the best course of action for this liquidity event. It might be better to implement a same-day sale on the NSO because it's taxed at the time of exercise. The decision is clearly a complex one.

To learn more about scheduling a liquidity event workshop for your company, speak to a First Citizens wealth consultant today.