What Happens With The Developer's Equity When The Company Goes Through an IPO?

What happens when the company goes through an IPO? In general, IPO makes things much more straightforward, comparing to the acquisition scenario.

Once the IPO is done, you can look up the share price on the stock exchange (with which you’re going to get an account), and decide to exercise your options and sell stocks you hold.

There’s one catch.

To prevent all the employees from selling their stock on day 1 of the IPO, the lock-up period is enacted within which employees cannot exercise or sell their stock on the public market.

Otherwise, all the employees who (finally) can liquidate their stock/options positions would flood the market with sell orders, and that will tank the share price (because of supply/demand problem).

Since the IPO is a way of fundraising, if that is allowed to happen, the company will lose a lot of potential capital. And employees will lose a lot of economic value too.

The usual lock-up period is 90-180 days. That means that you cannot realize your gains for 3-6 months after the IPO.

Additionally, each quarter there will be more “quiet” periods to make sure that employees selling a lot of stocks don’t give “bad signals” to the market before the quarterly financial report is released.

Essentially, after the lock-up period, you’ll only have a few weeks of the window of opportunity every quarter to do anything with your stock.

The easiest way to liquidate your position is to use the so-called cashless exercise of your stock options. Let’s imagine you haven’t exercised any of your options before the IPO:

Your grant #1 (from 3 years ago):

• Exercise price: 10 cents per share.

• Vested options: 150 * 75% = 112 options.

• Exercised options: 0 options.

• Unexercised options: 112 options.

• Unvested options: 150 * 25% = 38 options.

Your grant #2 (from 1 year ago):

• Exercise price: 10 dollars per share.

• Vested options: 100 * 25% = 25 options.

• Exercised options: 0 stocks.

• Unexercised options: 25 options.

• Unvested options: 100 * 75% = 75 options.

Usually, exercising your options would require you to pay your hard-earned money for them (at exercise price). With cashless exercise, you can combine exercise and sell orders into one. You can do it only if the market price is higher than your exercise price, of course. Here’s how it’d look like:

Current market price: 237 dollars per share.

• Exercise order (#1): 112 * 0,10 = 11,20 dollars you’d have to pay.

• Sell order (#1): 112 * 237 = 26.544 dollars you’d gain.

👉 Result (#1): 26.544 - 11,20 = 26.532,80 dollars gain.

• Exercise order (#2): 25 * 10 = 250 dollars you’d have to pay.

• Sell order (#2): 25 * 237 = 5.925 dollars you’d gain.

👉 Result (#2): 5.925 - 250 = 5.675 dollars gain.

🚀 Total gain: 26.532,80 + 5.675 = ~32K

As you can see, with that current market price, it didn’t make sense to exercise/sell. Remember, you’ve invested ~60K in lost opportunity cost, so ~32K return is pretty bad—46% loss on your investment.

If you think the market price will go up, because the current price doesn’t make any sense, it makes sense to wait. If you believe the price is much higher than what it should be, you should cut your losses, liquidate your position, and re-invest the cash into something else (preferably diversified).

Also, such a cashless exercise, depending on your country, may result in the worst tax burden. You could lose 45% and more from that transaction in taxes. It’s best to talk to your tax advisor about how this liquidation can be planned better.

Here’s one bad scenario that could happen from cashless exercise in, e.g., Germany (tax bracket 42%):

• Total gain: ~32K (considered employment income)

• Taxes (42%): 13.440

👉 Net gain: ~18,5K

For example, it makes sense to exercise the option in some countries first, then hold the stock for at least one year, and then sell it—proceeds will count under much lower tax bucket (capital gains instead of employment income).

Additionally, it may make sense to exercise when the market price is very low. This way, the difference between the exercise price and the market price is minimal, and you pay the least possible taxes on that “discount.” That is because this difference is your salary at the moment of exercise. And then sell the stock when the market price is going up again.

Here’s how this strategy could look like:

Wait for the market price to go down: 41 dollars per share.

• Exercise order (#1): 112 * 0,10 = 11,20 dollars you pay.

• You hold now (#1): 112 shares 41 dollars each.

• Your employment income (#1): ~4,5K

• Your tax burden (#1): ~1,9K (42%)

Let’s say you don’t have ~1,9K lying around to pay for this tax right now. So how about we turn this order instead into a partial exercise/sell to cover that additional expense:

• Exercise order (#1): 112 * 0,10 = 11,20 dollars you’d have to pay.

• Partial sell order (#1): 47 * 41 = ~1,9K you’d gain.

• You hold now (#1): 65 shares 41 dollars each

• Your employment income (#1): ~4,5K

• Your tax burden (#1): ~1,9K (42%)

This way, you are losing about 42% of your shares—they are converted to cash to pay your employment taxes.

Now, for the second grant, let’s say that you don’t have enough cash right now to spend 250 bucks on something that you think is maybe too risky. Okay, you can use partial exercise/sell to pay for your full exercise:

• Exercise order (#2): 25 * 10 = 250 dollars you’d have to pay.

• Partial sell order (#2): 15 * 41 = 615 dollars you’d gain.

• You hold now (#2): 25 - 15 = 10 shares 41 dollars each.

• Your employment income (#2): 775 dollars.

• Your tax burden (#2): 325 dollars (42%)

Now in total, you have 75 shares, 41 dollars each.

Now, let’s say you wait for one year and wait for the company to get to its “real stock price” on the market. Let’s say this day comes, and you decide to sell:

Wait for the market price to rebound: 1270 dollars per share.

Sell order: 75 * 1270 = ~95K capital gains. Your tax burden: ~24K (25%). Your net gain: ~71K.

At this point, this return on investment is only modest: 58% total ROI. And you had to wait for it 1,5-2 years more, which means that it’s only 11% yearly return. Indeed, if you had these 1,9K to pay in taxes, you would have had more shares at this point and more prosperous. But you never knew if it will recover to this level.

Also, as you can notice, taxes is a vital topic. They can eat your returns significantly. And there are ways to optimize them if you’re willing to do some proper tax planning and hold shares a bit longer. Otherwise, they just become your deferred paycheck—and are taxed accordingly.

No matter if the company goes IPO or gets acquired, you can get either stupid rich, or get modest returns, or get nothing. Many will say it’s a gamble, and of course, it is—when one doesn’t know what they are doing and doesn’t have the control.

The more you know precisely why this start-up is highly valuable, and the more control you have in the early days of the company, the more likely it’s less of a bet and more of a calculated risk-taking.

That is why, the more critical your role, the more stock options you should be considering, and the lower your position—the more cash compensation you’d want to get instead. Also, the more sure you are that the company just HAS to become successful, the more options you’d want to get, and vice versa.

Finally, what if neither IPO, nor acquisition is anywhere on the horizon, but you want to realize your gains earlier?

🏃‍♂️ How can I “exit” quicker?

Let’s say that you have most of your options vested, and you have already exercised them all. No IPO planned, business is booming, and no acquisitions are on the horizon.

What are your options to “exit” early as an employee?

If you read your stock plan agreement, you’ll often find restrictions on who you can sell your stock while the company is private. Most often, you’ll see that you can sell to any other employee in the company.

Knowing that you can start asking people whether they are happy with their amount of stocks/options, and see who wants to have more ownership/stake in the company.

Once you’ve found them, you can negotiate on the price of your stocks. Then you sell.

This process is done on paper or in electronic documents. There aren’t any digital exchanges for this. Such a transaction has to be peer-to-peer to be legal.

Rarely, companies introduce a “2nd market” for stocks. That is when you do have some exchange, that will make it easier for you to find a buyer for your stock.

If you’re good at negotiation, you can even sell it for a great price! Alternatively, the opposite is true: if you want to get more stake in the company, you can find other employees who want to “cash out early.” You can give them this opportunity for a premium price (you get stock cheaper).