By |Published On: Apr 15, 2024|Categories: Financial Planning, ISOs|

With pre IPO ISOs you have the “option” to buy shares in your early stage company. There are many different phases of pre IPO companies from seed stage businesses all the way to companies that are about to “go public.”

Additionally, there are many aspects to ISOs that you should consider before spending money from your own pocket to increase share ownership in your employer.

ISO Recap

Remember that if you hold ISOs long enough – one year from the option exercise date and two years from the grant date – ISOs have long term capital gains. However, if you don’t hold the shares for the required period, they become NSOs and lose their favorable tax treatment.

Moreover, you may be subject to the Alternative Minimum Tax (AMT) because ISOs are a special item under the AMT.

Finally, there is a $100,000 calendar year limit on the vested value of ISOs.

Aside from the ISO mechanics, there are different scenarios based on the timeline of your company.

Pre IPO ISOs at an Early Stage Company

Because the company is young, the exercise price of the options and the fair market value of the shares are typically very close to each other. As a result the potential Alternative Minimum Tax (AMT) impact is small. Sometimes the exercise price and fair market value may be the same – no AMT! So check your documents.

If you hold the shares for longer than 5 years and the business is structured within the appropriate guidelines, you may qualify for the Qualified Small Business Stock (QSBS) exclusion. Some or all of your capital gains can be excluded from federal income taxes.

However, there is a lot of uncertainty about the future of an early stage company, and you could spend money on shares in a business that never goes anywhere. Or worse, the company fails, leaving you with a loss.

ISOs at a Business That Will IPO Soon

If your company is about to “go public,” there are a lot of advantages to owning ISOs. One, you will know what the shares are worth because there is an active market. This will help you determine their value and potential AMT impact.

Furthermore, you can coordinate exercising your options with other forms of equity ownership in a tax-efficient manner. Because there is a liquid market for company shares, you can do a cashless exercise and not have to use your own cash to purchase the options.

Even though your company plans to go public, the IPO may never happen. If this is the case, unfortunately, there won’t be a market for you to sell your shares.

On the flip side, when your company does go public, you must wait up to 7 months to sell the shares due to the lockup period. Also, to qualify for the long term capital gains tax, you must hold the shares one year from exercise to sale. Holding shares for one year in a public company is a long time and the share price can move up or down quite a bit.

Is It Wise to Exercise ISOs?

When’s the best time to exercise your options? Well, it’s important to know how much cash you are willing to spend and potentially lose.

When you purchase options in an early stage company, you don’t know when you will be able to sell them. Will you have a qualifying disposition (long term capital gains)? What will the share price be? How much money, if any, will you make?

The cash required to buy ISOs is equal to the exercise cost of the options plus the cash paid in potential AMT.

The futures of companies are often unpredictable! Sometimes they work out the way you hope and other times they do not.

The most important question to ask yourself:

If the company is a bust, how much cash out of pocket am I willing to lose?

To understand what ISOs mean for you, set up a time to speak with me!