Did you know that before taking a swing, many professional golfers visualize their shot flying and landing where they will aim? Or that race car drivers carefully focus their eyes on where they want their car to go instead of the road directly in front of them?
What you focus on has powerful implications for where you will go in your personal life, your career and more. We believe your finances are no exception, which is why it’s critical to have the right focus for your equity grants.
A Crystal Ball Would Be Nice Right About Now
Unfortunately, one of the most common pitfalls we encounter is when people mistake a tax projection for a crystal ball. Don’t get us wrong, tax projections can be very helpful and we frequently utilize them as part of our analysis. But tax projections are estimates, not a guarantee.
In the context of equity grants, we find them most useful for comparing one diversification scenario with another. They help us to assess whether one potential path may result in less taxation than another. When there’s a lot of dollars at stake that can be a really interesting data point.
But what surprises many people is that saving money on taxes doesn’t necessarily mean a better outcome. This sounds counterintuitive, mostly because no one likes sending checks to the IRS but let’s look at a hypothetical scenario:
The Sad Story of Tech Bro
Tech Bro works at Snap, Inc. and had 100,000 incentive stock options (ISOs) with a fictitious strike price of $3.46/share. Prior to the IPO he ran some tax projections that made a compelling case for exercising and holding for a year. Trying to save on taxes seemed like a slam dunk approach to maximizing wealth.
So on the first day of trading, he eagerly exercised his ISOs when the stock was trading at $24/share. But as we all know the stock price subsequently dropped. So by the end of the year he was left with a painful choice -- pay the hefty Alternative Minimum Taxation (AMT) and hang on or sell. Brutal.
It’s important to think through cash flow considerations. Where would Tech Bro get the money to pay for the taxes in Option 1? He hasn’t sold any stock yet.
Unfortunately, there would be no fairytale ending. If Tech Bro had managed to pay the AMT and wait a full year he probably would have sold at an even lower stock price (it went as low as $4.99/share in 2018). The benefit of the lower Long Term Capital Gains (LTCG) tax rate still wouldn’t be enough to offset the reduced wealth from stock price volatility.
So how did this happen?
There’s no question this was not the intended outcome. And to be clear, we’re not suggesting it’s the result of running tax projections. Tax analysis is not the enemy here. The real problem comes when you focus on the wrong thing.
If your only objective is to maximize your equity grant proceeds - you’re not planning, you’re gambling. Sadly, we have yet to hear of anyone with a crystal ball. Sigh.
Ok, Then What’s The Correct Focus?
Ultimately, what we believe is a more luminous vision is one that focuses on how likely you are to accomplish your financial goals, not how likely you are to save money on taxes. The former can be impacted by the latter but there are a multitude of other productive considerations.
One key consideration is risk. A plan that ignores or doesn’t properly account for risk probably isn’t very helpful if you’re trying to figure out what to do with your equity grants. Stock prices move up and down. And it’s important to evaluate whether or not your volatility fits within your risk profile.
It’s also important to understand whether or not that risk is helpful or hurtful in the context of your planning. Would you be better off selling some, most, or all of your equity? You’d only be able to determine that by modeling how each scenario compares on a risk adjusted return basis.
And that’s a conversation that involves investments. So it’s important not to overlook how you could or plan to invest your equity proceeds. Identifying the right investment strategy is just as important as crystallizing the right tax and diversification strategy.
It all needs to work together.
Determining the risk of post-IPO stocks can be tricky because of limited trading history. Try to find a credible benchmark or work with a trusted financial advisor to create one.
You Don’t Have To Be Like Tech Bro
The good news is that creating a winning vision is within reach. It just potentially requires expanding your focus beyond where you started. But we’re confident the hard work is well worth the effort.
Can you imagine creating a plan that allows you to eliminate self doubt, the fear of missing out and the frustrations that can come from DIY solutions? That’s what we’ve seen happen when people identify the correct vision.
If you’re navigating an IPO (or Direct Listing) don’t miss out on your opportunity to download our planning checklist. It’s based on our experiences guiding clients through real life events - like the Uber, Lyft and Dropbox IPOs - so the steps included are battle tested.
It also comes with a free video to walk you through the entire planning process and an offer for a complimentary review. That way you can validate if you have the right vision and can move forward with the confidence you deserve - no crystal ball required.
Please review our disclosures and discuss your situation with a financial professional before making any investment decisions.