Should you sell? How much should you sell? When should you sell? These are burning questions during liquidity events.
In Part I of this discussion on IPO and direct listing considerations, we took a look at tax consequences. Today, we dive into key selling considerations.
When Should You Sell?
Regarding the “when” question, be aware that you may not be able to sell your shares right away—your options and held shares may be subject to a lockup agreement. This means that you won’t be able to sell part or all of your shares before a certain date.
A lockup agreement can complicate planning, particularly if your stock options are expiring before the lockup ends. Knowing your option expiration dates is critical.
A Question of Planning
The question of whether and how much to sell is primarily a financial planning and investment decision.
Several factors that go beyond tax considerations are involved in thinking through the answer. Probably first and foremost is the portion of your total net worth that your vested and unvested holdings in the company’s stock represent.
If this is your first liquidity event and your holdings in your employer’s stock—either through shares you already hold or shares you control through stock options—are a high percentage of your net worth, say 50 percent or more, then you will want to strongly consider selling some of your holdings right away to begin the diversification process.
If you have had several liquidity events and are financially comfortable, and the value of this stock represents, say, less than 20 percent of your net worth, then diversification isn’t as urgent for you.
Of course, if you knew what the stock price was going to be moving forward, you’d know exactly what to do. If you knew the stock price was going to climb, you’d hold on to your shares. If you knew the stock price was going to drop, you’d sell first.
It’s impossible to know the future, though, and you’ll have to make a decision based on uncertain information. The more you can afford to withstand a loss, the less important getting it just right is for you.
The Company’s Prospects
Another important factor in the decision to hold or sell is what the company’s prospects are going forward. This is a trick question, really. The company has probably just completed a period of rapid growth, and the company’s executive team felt confident enough in the company’s near-term performance to move forward with the IPO or direct listing.
But recent success doesn’t guarantee future success. The company may be raising money because it needs to fund operations, in the case of an IPO, or it simply may be providing liquidity to its investors, in the case of a direct listing.
Neither of these scenarios provides much bearing on the future performance of the company or its stock price. Fast-growing companies that complete an IPO or direct listing, particularly small technology companies, typically operate in chaotic, uncertain environments, and their fortunes can change rapidly.
Why Diversification Is Important
You might feel some reluctance to diversify, even if you know or suspect it’s the right thing to do. And you should understand those feelings are completely normal.
You may feel an emotional attachment to your company and find it difficult to part with the shares you worked so hard to earn. You also may feel confident in the company’s future, perhaps overly confident, because you are familiar with its operations. You might have fear-of-missing-out if the stock price moves higher, or worse yet, spikes to the upside.
Diversifying doesn’t mean you won’t earn a good return on your money. You’re simply moving your money from the risky bet on a single stock to a safer, fully diversified investment portfolio that can more reliably meet your financial goals, such as retirement, buying a new home, paying for the kids’ college, etc.
If you have more unvested options or restricted stock units (RSUs), you will have continued upside in those unvested shares. For many employees going through a liquidity event, unvested options or RSUs can represent a significant portion of their total net worth. With so much unvested equity compensation, it can make sense to sell more of the vested shares in the near term.
Many companies also refresh RSUs or options after a liquidity event to help ensure they retain valuable team members, so you may have more stock on the way.
Choosing the Time Period to Sell
Once you’ve decided to move forward with selling and diversifying, you’ll need to decide over what time period to sell. Assuming you don’t have any particular insights about the company’s performance or stock price in the future, which is a good assumption for most people, regular, periodic sales over a predetermined period of time are a good way to avoid selling on particularly bad days.
Sales need to be planned around “trading windows,” which are periods when the company prevents employee trading, typically around earnings announcements. Company insiders may want to consider selling pursuant to a 10b5-1 plan, which is helpful in staying clear of insider-trading violations.
One last point: Timing is an important consideration for your unexercised stock options. The value of a stock option can be separated into two main parts: its intrinsic or “in the money” value, which is equal to current stock price minus strike price, and its time value.
The time value of an option depends on the amount of time until expiration, volatility of the stock price, and the current interest rate on the safest U.S. government bonds. The longer the time to expiration, the higher the volatility; and the higher the interest rate, the greater the time value of a stock option.
Generally, good candidates for exercise include options in which a large percentage of their total value is intrinsic value and a small percentage of their total value is time value.
Deep in-the-money stock options are typically exercised first (and possibly sold first depending on whether they are ISOs or NSOs) because there is more intrinsic value to lose and less upside, measured by time value, to gain. At the time of an IPO or direct listing, the oldest options that were granted earlier often have the most intrinsic value and typically can be considered for exercise first. Newer options, which often have a higher percentage of time value compared to the options granted earlier, typically can be considered for exercise later.
In addition to tax considerations, diversification goals, and investment outlook, the relation between intrinsic value and time value of options should be considered when deciding which options to exercise and hold or exercise and sell.
This is complex territory, but these considerations are worth understanding. If you’d like to learn more about this, a good resource is my book, Personal Finance for Tech Professionals.
