Pre-IPO Stock Options and RSUs: What You Need to Know

If you work for a high-growth private tech company, chances are a big part of your compensation comes in the form of stock options or RSUs. And if your company is preparing for an IPO, or you think one may be on the horizon, you’re probably wondering what all of this means for your future.

Equity can be one of the most valuable parts of your financial picture, but it can also be one of the most confusing. Terms change, tax rules shift, and the path from “private shares” to “public wealth” isn’t always straightforward. 

You need a clear understanding of what you actually own, how vesting works, what could happen during an IPO or Special Purpose Acquisition Company (SPAC) merger, and what steps to consider before your shares become liquid.

As a San Francisco financial advisor specializing in assisting tech employees, I’ll walk you through the key things you should know about pre-IPO stock options and RSUs: what they are, how they work, and the decisions that will matter most as your company moves closer to going public. 

We’ll look at some of the top questions tech employees ask about pre-IPO stock options and RSUs, such as: 

1. What happens to my stock options or RSUs when my company goes public?

2. Should I exercise my stock options before the IPO?

3. What is an 83(b) election, and do I need one?

4. How are pre-IPO stock options and RSUs taxed? 

5. What is a lock-up period, and when can I actually sell my shares?

6. What’s the difference between ISOs and NSOs?

7. How do SPACs affect my equity?

8. Will my shares lose value after the IPO?

9. Can I sell my shares before the IPO?

10. What happens to unvested RSUs during an IPO?

11. Do I need a financial advisor to help plan for my IPO?

12. How do blackout periods and trading windows work?

13. What is double-trigger acceleration?

14. What should I do with a large tax bill after exercising?

15. How do I avoid AMT when exercising ISOs?

How to make pre-IPO stock option decisions

Once your pre-IPO stock options transform into actual wealth, you’ll face complex choices, as your tax consequences could range from a few thousand to several million dollars. With such substantial amounts on the line, it’s paramount to understand how to handle your pre-IPO stock decisions.

Equity compensation typically comes in three main varieties: 

• Incentive stock options (ISOs)
• Non-qualified stock options (NQSOs)
• Restricted stock units (RSUs). 

Early-Stage employees are often granted ISOs or NQSOs, while RSUs are more common as the company nears a liquidity event. Interestingly, the specific equity type you’re awarded can hint at how close your employer might be to a major exit.

Every form of equity has distinct tax rules and requires unique decision-making both before and after an IPO. Below, we’ll discuss each category, starting with ISOs (the most intricate) and finishing with RSUs (the most straightforward). As a San Francisco CFP®, my goal is to equip you with the knowledge necessary to make informed decisions about your pre-IPO stock.

Deciding when to exercise your ISOs

Your trickiest pre-IPO equity decision often involves determining when to exercise your incentive stock options (ISOs). This question can arise as soon as you’re granted your pre-IPO stock options. AMT (Alternative Minimum Tax) and specific holding periods make ISOs particularly challenging.

Chances are you’ve already explored ISOs elsewhere, so I’ll refer to additional resources for deeper info. Ultimately, ISOs revolve around timing: exercising early, exercising before an IPO, exercising afterward, and deciding whether or when to sell. 

Understanding the tax implications, especially how to transition from ordinary income to long-term capital gains while managing AMT, should guide your approach.

When you exercise ISOs, the difference between the strike price and exercise price doesn’t become income or capital gains until you sell. This is a stark contrast to NQSOs, which trigger ordinary income tax at the time of exercise. 

If there’s a considerable margin between your strike, exercise, and eventual sales price, shifting those gains to long-term capital gains can save an enormous amount in taxes.

However, that potential benefit also brings AMT into play. The gap between strike and exercise is viewed as an AMT preference item. If your overall income plus this “phantom income” is high enough, you might face a hefty tax bill, which would counteract some ISO benefits. This is where the services of a fiduciary financial planner in San Francisco can be of great assistance to you as you navigate your employee compensation options.

Timing of exercising your ISOs

One tactic to control AMT is to minimize the spread between the strike and exercise prices. By definition, ISOs must be offered at the company’s current pre-IPO valuation. At grant time, your strike and exercise prices match. However, your shares are likely not vested on the grant date.

Early exercise allows you to buy unvested shares before they formally vest, thereby shifting AMT timing and accelerating the qualified disposition clock. You’ll need to file Form 83(b) with the IRS to accomplish this. 

Here are the key considerations:

1. Forfeiture Risk: If you leave the company before vesting, you return the shares at your original exercise price, not their (potentially higher) market value.

2. Tying Up Cash: You’ll need personal funds to exercise pre-IPO stock, unlike a public firm, where a “cashless exercise” might be an option. Be prepared for a scenario in which the shares never become fully liquid or might take years to realize any return.

3. AMT if the Valuation Rose: Should you exercise later in your employment (when the spread is larger), your income and that spread might trigger AMT. If no exit occurs, you may be left with a tax bill and no liquidity.

4. Disqualifying Disposition: Selling before the qualified disposition deadlines nullifies early exercise benefits, and some of the spread and gains from the sale may be taxed under ordinary income brackets.

Tech professionals who exercised their options early in booming startup environments often reaped significant tax savings. 

If you’re optimistic about your employer’s trajectory and comfortable with the financial risks, early exercising can prove to be a smart strategy.

Exercising your ISOs before an IPO or exit

Exercising your ISOs ahead of an IPO shares many similarities with early exercising. However, two notable distinctions stand out:

1. Ownership: A standard (non-early) exercise implies your shares have vested, reducing the possibility of forfeiture if you depart the company.

2. AMT Liabilities: If the firm’s valuation has appreciated substantially, the spread between strike and exercise might pull you into AMT territory. That’s especially problematic if the exit flops (as some WeWork employees painfully discovered).

Consider timing your exercise roughly six months before a presumed IPO date, overlapping with the typical six-month lock-up period that typically follows an IPO. 

This approach can align the one-year holding requirement with your first chance to sell. But always confirm the type of exit: a direct listing, SPAC, tender offer, or standard IPO, and then choose your exercise timing accordingly.

Watch my video on “How to Protect Your Investment Gains and Should You Time the Market?”

Exercising your ISOs after an IPO or public exit

Once your employer goes public, exercising becomes less risky, and you have more flexibility.

• You can sell enough shares to cover the strike price after exercising, though you’ll pay ordinary income tax on those shares sold from an ISO lot.

• A public market for the stock allows you to utilize AMT credits more effectively later on. Some employees exercise early in the year and observe how the stock performs. If it plummets substantially before December 31, a disqualifying disposition might result in a smaller total tax bill than paying AMT at a higher valuation.

Deciding when to exercise post-IPO often depends on how much AMT you’d trigger. Spreading out exercise events over multiple tax years can prevent a single colossal AMT hit. These scenarios are usually complex enough to warrant professional modeling from an experienced CFP ® in San Francisco.

When should you sell your ISO shares?

You may opt to sell before satisfying ISO holding requirements for several reasons:

• If you need the proceeds to exercise, or if you just can’t fund the exercise cost from your own resources.
• By year’s end, if you realize your AMT liability is huge, you might sell some shares to handle the tax bill.
• Once you satisfy the one-year (post-exercise) and two-year (post-grant) holding requirements, you could have a significant profit. However, you may still weigh whether further stock growth is worth the extra risk.

Keep in mind that if you paid AMT at exercise, AMT credits may offset part of your capital gains tax. 

Ultimately, your decision to hold or sell hinges on personal financial considerations, your level of confidence in the company, and your willingness to navigate further tax complexities.

Watch: What is Tax-Loss Harvesting?

Exercising NQSOs and tax considerations

Compared to ISOs, NQSOs involve fewer tax complications. 

Exercising NQSOs triggers ordinary income tax on the spread between exercise and strike immediately. Any additional appreciation after exercise is considered capital gains, taxed at either a short-term or long-term rate depending on how long you hold it.

Since NQSOs don’t offer special tax benefits from more extended holding periods, many professionals opt to sell the shares right after exercise, if a market is available. If your firm is still private, though, that can be tricky.

Capital Gains Considerations When Exercising NQSOs
You might see a scenario where you exercise now and plan to sell only after a future IPO, capitalizing on any price escalation. Although it can be tempting, you risk paying ordinary income tax on gains that might never materialize if things go south (again, the WeWork fiasco).

Combining ISOs and NQSOs
Some employees receive both pre-IPO stock options (ISOs and NQSOs). If you already have enough ISO activity to push you deep into AMT, you may find room to exercise NQSOs without massively inflating your total tax burden. However, modeling this accurately requires professional advice, as AMT interacts in complex ways with ordinary income, especially at higher income levels.

Holding an unexercised NQSO
One overlooked concept is the time value of an option. Holding an unexercised NQSO means you retain all the upside potential without shouldering the downside if the stock drops, provided the option hasn’t expired. Exercising early forfeits this safety net.

What to do with RSUs at IPO

Of the three main equity types, RSUs are generally simpler but can be unsettling during an IPO or exit. Let’s explore why.

• Double Trigger: For many pre-IPO RSUs, vesting requires two conditions: a time-based vesting period and a liquidity event. You won’t actually receive those shares (or face the resulting tax) until both triggers are met.

• Tax Treatment: When RSUs vest, their total market value is taxed as ordinary income, including payroll taxes. Unlike stock options, you’re not deciding on a strike price or partial exercise. You will receive your shares—and the accompanying tax bill—once vesting is complete.

• Tax Withholding: Typically, a portion of your shares will be withheld to cover initial taxes, though it may still fall short of your total tax liability. Being aware of how much was withheld vs. how much you’ll owe by the next tax deadline can help you avoid an unpleasant surprise.

• RSUs and Traditional IPOs: If you meet the time requirement before the IPO, you may end up with a substantial amount of RSUs vesting all at once upon the liquidity event, thereby creating a massive taxable event in a single year. If the shares then lose value during the lock-up period, you’ll feel doubly frustrated: taxed at the higher IPO-day value, forced to sell at a potential discount six months later.

• Leveraging RSUs to Offset AMT: On the flip side, all that ordinary income from RSUs may neutralize some or all of your potential AMT if you also exercise ISOs in the same year. Because these two tax systems operate in parallel, a spike in ordinary income could lower your AMT liability.

How Wealth Script Advisors Can Help You Move Forward with Confidence.

Equity compensation can open incredible opportunities, but it also comes with tax decisions, timing questions, and a lot of moving parts, especially as your company approaches an IPO, merger, or major liquidity event. You don’t have to sort through it alone.

At Wealth Script Advisors, we help you make sense of your stock options and RSUs within the context of your complete financial picture. This involves understanding how your equity aligns with your long-term goals, assessing the tax implications of your choices, and developing a clear plan for exercising, holding, or selling your shares.

Given the time-sensitive, high-stakes, and often intricate nature of these decisions, partnering with a knowledgeable financial and tax professional is vital. We’re different because we have real-world experience guiding tech employees like you on complex employee comp strategies.

With the proper guidance, your equity can become one of the strongest building blocks of your future. If you’re ready to take the next step or simply want a second opinion, we’re here to help you make informed, thoughtful decisions every step of the way.

You can schedule a quick 15-minute call by clicking here.