Last weekend, I met up with Sophia, my lifelong friend, over lunch at the local pizza place in our hometown. You know the kind that has the large, piping hot pizza oven with the little flip door and the slices are sooo good!
Sophia is so awesome – valedictorian of her class, full of fun and adventure, and such great storytelling. She is working at a mid stage healthcare AI startup and recently the company announced a Tender Offer.
What is a Tender Offer?
Early to mid stage startup employees, like Sophia, are vesting Incentive Stock Options (ISOs) and they struggle to make decisions about them. Uncertainty around cashing out and the future value of the shares results in the same decision – employees do not exercise.
When your company announces a Tender Offer, you have the opportunity to cash out of an illiquid stock.
The textbook and rather boring definition of a Tender Offer is a company will buy vested stock from employees at a set price by a certain date.
I like to refer to Tender Offers as “delicate decisions” because they are challenging. Most of the time, employees who participate with unexercised ISOs do not take advantage of them.
Delicate Decision with ISOs
Sophia has an ISO grant for 100,000 shares with a 4 year vesting schedule. She’s been at the company for 3 years, so 75,000 ISOs are vested.
The company made a Tender Offer to purchase 20% of her vested stock (15,000 shares) for $15 per share. At this time, the company’s 409(A) valuation is $10 per share, so that’s a nice premium. An independent third party determined that the business is worth $10, and now a buyer (investors or the company) will pay $15.
Furthermore, her exercise price on the shares is $2 per share. This means she can buy the shares for $2 and then sell them right away for $15!
Hold your horses – this is where it gets “delicate.” Not holding the ISOs for the required time period (12 months from exercise and 24 months from grant date) means that the sale is a disqualifying disposition.
When an ISO is sold in a disqualifying disposition, the spread – the difference between the sale price and purchase price – is taxed at ordinary income rates. So with this sale, Sophia’s income tax will increase by $13 per share.
At this point, Sophia has not exercised any options. She can participate with a cash or cashless exercise and her tax situation will be the same with a cash or cashless exercise.
Framework for the Delicate Decision
How much money does Sophia want to put in her pocket? The chance for her to sell stock in an illiquid company is rare. When the sale price is significantly above the exercise price of the options ($15 vs. $2), it could be worth capturing these gains.
The downside is twofold:
- Paying tax at ordinary income rates
- Fewer shares to participate in future upside in the price of the shares
It’s best for Sophia to choose the cash number that is best for her because trying to fully optimize the “delicate decision” gets into a circular argument and will cloud her judgment.
Further on Down the Road
Remember how Sophia’s sale was a disqualifying disposition? Let’s go one step further and introduce yet another “delicate decision.” The only way to have a “qualifying disposition” and pay the tax on the spread at lower capital gains rates is to meet the 24 month and 12 month thresholds mentioned early. So she must exercise shares!
Sophia can use some of the Tender Offer cash and exercise (and hold) shares. She must take the following factors into account:
- Investment risk on owning the company shares
- Expiration date on the ISOs
- Alternative Minimum Tax (AMT) on the ISOs
Sophia’s Decision
Sophia decided to fully participate in the “delicate decision” and sell 15,000 shares by using a cashless exercise. After all the taxes were paid, she put $77,500 in her pocket, and earmarked another $20,000 to exercise 10,000 ISOs when they vest later this year.
Your Delicate Decision
There are many aspects to consider when evaluating a Tender Offer – your needs, your comfort, and your feelings. Risk is always present. Sometimes, you can sell shares now and then the price can go up. Other times, you exercise options now and the price may decrease.
If your company extended a Tender Offer and you are pondering what to do, we can chat about this delicate decision.