Lesson Fifteen: Patience is a virtue but a plan is a requirement

Knowing the "why" is how you get there

I think that it is a simple fact that most people decided to work at crazy, fast paced, sometimes soul crushing, always requiring max effort, built to change the world start ups for one main reason. They want to make a lot of money on the day the company makes its Initial Public Offering. As I wrote back in the introduction I knew some early Google employees and they could basically buy a private island.

I have lived through three IPOs and each was unique. I have had an experience that I think is more typical of Silicon Valley rank and file. I am not buying a private island any time soon, but I am also able to provide a better than average quality of life for my wife and daughters. We own a home in one of the craziest places to try and buy a house. Basically, I have no complaints about our financial situation and this is the direct result of working for companies that had yet to offer stock on a public exchange.

I think it is pretty important before I write anymore in this newsletter to make sure that I point out I am not a Financial Advisor. I will not be recommending any stocks and I am not qualified to offer anything but my opinion when it comes to financial planning. If you are working for a company that is not public yet, you should reach out to a professional to come up with a specific plan that meets your goals.

The first part of understanding what your plan should be is to understand what your specific goals are. For my wife and I, our goals were to buy a house in Pleasanton, CA and to send our three daughters to whichever college they wished to attend. We had some goals beyond that, but these were the bedrock, foundational goals of what we wanted to increase our personal wealth to meet. 

This is another thing that is important, you don’t want to limit your goals. We also really love visiting Whitefish, MT in the summer. We agreed it would be great to have our own place in Whitefish to spend the Summer, but that is a goal that sits behind the foundational goals. It is something that we absolutely have to have, it is a nice to have. Make sure you think of goals in that way. You should have tiers of goals and know which makes sense to tackle first.

Really, none of this is specific to working at a pre IPO company. These are just the basic underpinnings of any financial plan that any of us make. So what is different about pre IPO financial planning?

The real difference is that you have absolutely no idea what the value of your equity will be on the day the company goes public or on the day you actually are able to trade the stock. There is going to be a difference, it will have tax implications for you and there are a lot of other things that you are going to want to consider when you are making a plan. And this is just the tip of the iceberg when it comes to information you are going to want to understand in order to have a decent idea of how to answer the series of questions you will be faced with.

First, equity value is an important thing to grasp and not as straightforward as it sounds. When I joined Facebook I was given a certain amount of Restricted Stock Units. Folks who came earlier were granted Stock Options. There is a difference between those two types of equity and you should make sure you understand which type you are being offered.

Make sure you talk to a Tax Advisor about your particular situation. If you join a company before they have a $1B private valuation, chances are you will be offered Stock Options, which have a strike price. If the company has already achieved “unicorn” status (this is what pre IPO companies with a $1B valuation are called in Silicon Valley) you will most likely be issued RSUs and they have a $0 strike price. Because of this difference, you can expect to get fewer RSUs and achieve the same overall value because you have no strike price to cover when the grants are exercised.

These two methods of issuing equity grants to employees have very different tax rules. RSUs are not actually stock until the company goes public and they are taxed at the valuation of the company on the day they go public, which is the triggering event that makes them actual stock. The companies I have worked for that issued me RSUs sold a portion of my holdings on the day of exercising to cover the taxes. This was an amount equal to about 45% of the total value of vested RSUs on the day of going public. So, if your shares that have vested prior to the public offering are worth $1,000,000 on the day of the public offering… the company will sell $450,000 worth of shares to cover the taxes you owe.

Options, on the other hand, are more tricky to manage. When Options are issued to you they will be issued at whatever the valuation of the company is as of that Quarter. This means that the total valuation of the company divided by the total number of outstanding shares will be the value of the individual Stock Options on your grant. As they vest, you will have the opportunity to exercise them before they are publicly traded, file a tax form and pay taxes when they are actually sold in the future. If you hold them for more than a year after this early exercising action, you will pay Capital Gains rather than Income taxes, potentially saving a lot of money.

You will also need to think about the Alternative Minimum Tax if you early exercise and the shares have grown in value from when they were originally issued. You will have an on paper gain with no way to actually sell the stock to cover any of the taxes. Another great reason to seek advice from a Tax Professional before doing anything with pre IPO Stock Options.

The other hard thing about exercising early is that if the Options are worth a great deal of money, you will have to have that cash on hand to exercise them. When I was at Square, I had the opportunity to exercise early and save myself a potentially large tax bill in the future. In order to do that, I would have had to sell Facebook shares. There was complicated math involving a lot of conjecture to figure out what the right path was there, but ultimately I decided to hold the Facebook shares and deal with Square taxes later. You may make a different choice if you work at two different game changers with different types of equity grants after you speak to a Tax Professional. Have I mentioned you should speak to a Tax Professional, yet?

The big celebration happens on the day of the IPO. The real big day is not really until the Employee Lock Out Period ends. At the companies I have worked for this was a six month period post IPO where my shares had finally become real and had actual dollar signs attached to them but I couldn’t sell any of them to convert them into cash. I will tell you right now that I learned very early in my time as an actual holder of Facebook stock that the best approach here is to avoid looking at the stock price.

For the sake of reviewing how I came to that lesson I am about to share some hypothetical numbers. These are not real but I am using round numbers so that it is simple and the point is still illustrated. When I came to Facebook there were two “classes” of employees from an equity perspective. Folks that come much earlier than I did were granted a higher volume of shares, as is typical. As the company grows the amount of shares they grant gets smaller for the same type of roles. It pays to be early.

Example Employee A came to Facebook before Example Employee B did. She was awarded 10,000 Options at a $3.00 per Option price. Six months before EEB joined Facebook, the company did a 6 to 1, stock split. EEA now held 60,000 Options with a $0.50 strike price. After EEB joined there was a 5 to 1 stock split. EEA now holds 300,000 Options with a strike price of $0.10. If you do the math you will notice that the actual cost of the shares to EEA has not changed at all. 10,000 * $3 = $30,000 and 300,000 * $0.10 = $30,000. 

Example Employee B started after the 6 for 1, and was granted RSUs instead of options. Since EEB came much later than EEA, the total number of RSUs granted was about half of what EEA was granted, again it pays to be early. EEB starts with 5,000 RSUs and those have a $0 strike price. EEB is present for the 5 to 1 split and so shortly after EEB starts he is holding 25,000 unvested RSUs.

Stock, initial stock grants whether RSU or Options, vest in 4 year cycles. Generally, the first 12 months nothing vests, then 25% of the stock will vest on or about your one year anniversary. So IPO day rolls around and EEA has been with the company for three years and EEB has been with the company for two years. Facebook went public at $41/share.

On that day, EEA has 75% of 300,000 shares, or 225,000 shares. Those are valued at $41 per share so EEA has $9,225,000 in vested equity. EEA has to exercise these options at a price of $0.10, so $22,500 comes off that number. IPO day has potentially set EEA up with $9,202,500. Depending on tax actions taken prior to the event, the real value of what is left in the stock account is going to vary, but for illustration's sake let us just say that EEA pays 45% taxes on this and is left with $5,061,375. 

Meanwhile, EEB has one year less service so 50% of EEB’s shares have vested. 25,000 * .5 = 12,500. EEB has, for a minute, 12,500 * $41 = $512,000. I say for a minute because as per the RSU agreement the company will sell 45% of those shares to cover the taxable event, leaving EEB with 6,875 shares. EEB’s stock account will show a total value, minus unvested shares and the 45% of shares sold to cover taxes with $281,875. 

The fun is really just beginning here. Remember back at the beginning of this I mentioned an Employee Lock Out Period. So while EEA has $5M and EEB has close to $300k in their respective stock accounts, they actually cannot sell those shares for six months. Within a week of Facebook going public the share price was cut tremendously and all of that value was cut about in half. 

At the end of the Lock Out Period, EEA and EEB were holding shares that were worth a little more than $21. EEA was holding roughly $2.5M and EEB was holding roughly $150k. This is not a real example, there are other things that have happened during this period of time, for certain. Six more months of vesting means that each of these employees have gained more shares that were converted from theoretical value to actual value. There have been more taxes paid, too. But to keep it simple we are just focusing on the initial chunk of vested shares that existed the day the company went public.

So what would EEA and EEB do at this point? What actions would you take if you were either of these imaginary people? The truth is, that is why you have to be very honest with yourself about the goals you started with and disciplined in chasing them. If I was EEA, and my goals were to have my three daughter’s college paid for, buy a house in the Bay Area, have a vacation home in Whitefish, MT and whatever else… I would be pretty close to hitting all three of those goals with $2.5M in cash.

If I am EEB, I have secured enough to potentially fund a down payment on the house in the Bay Area and those other two goals are for another day. But that is only on the specific day that I can first sell shares. What if I held on to them?

This question is the crux of every Silicon Valley pre IPO employee's life for the years following an IPO event. No one can answer that question for you, but you should seek a professional opinion. Just like I encouraged you a whole bunch at the top of the chapter to engage a Tax Professional, you should also seek a Financial Planning Professional. Sometimes, they will be the same person.

If we look at the price of Facebook stock on the last day of Q3 2020, it was $261.03. If we redo the math on those initial chunks of stock, EEA’s now probably doing whatever the heck she feels like with $32M. EEB is sitting pretty with $1.7M. In Facebook’s case, it looks like the right move was to hold that stock for as long as possible. That may not have been the obvious choice for people when the stock was worth roughly half of it’s IPO price six months later.

So the lesson of this chapter is easily boiled down to a single sentence: You should seek the help of a Financial Planning and Tax Management Professional before you do anything with the equity that you will earn at a pre IPO company. There are many reasons for that, but most importantly is that you are about to work your ass off to try and secure a brighter financial future and you want to make sure that is not wasted effort if and when that juggernaut in waiting blows the roof off the business world.

Make sure you have clearly defined goals. “I want to be rich” is not a goal. Make sure, if you have a significant other, that your goals are aligned. “We want to buy a house in the Bay Area” is better than “I want to buy a house in the Bay Area” if your spouse doesn’t really want to. “Teamwork makes the dream work” is a cliche but true.

Lastly, like I said in Lesson 5, remember the why and forget about the what. The discipline needed to reach the goals you have is easy when you remember why they are your goals.