Case Study: Stock Options
Jason Henderson is 42. Two years ago Jason and two friends created a startup called HPI. Jason has 1,000,000 incentive stock options at .01 each.
Jason wants to maximize the amount of money he can get and, being young, is willing to take some risk. Fluent suggested early on that he do an 83b election. This allowed him to pre-purchase his stock options prior them vesting. By doing this, he was able to purchase the options while the value was still .01, the same value as when they were given. Typically when stock options are purchased, the owner will fall under the Alternative Minimum Tax (AMT) and he will owe the difference between the value of the stock when purchased and the actual purchase price. If, for instance, Jason had waited to purchase his options when they vested, they would have been worth $3.00. Jason then would have owed taxes on $2.99 per share (taxes on $2,990,000). By exercising early, Jason owes no taxes. He now simply has to pay for the shares, which equates to $10,000. We were able to save Jason roughly $1,300,000 in taxes by taking this approach.
In addition to the tax savings, the clock on Jason’s holding period has started. To get long term capital gains tax treatment, and therefore favorable tax rates, Jason needs to own his stock for two years after they were granted and one year after they were purchased. Because he bought them early, when the company goes public he will have held all of his stock for more than this timeframe. When he decides to sell, Jason will then get long term capital gains treatment (currently 15% federal) vs. short term gains (currently 35% in Jason’s tax bracket, federal). This 20% tax savings is significant.
When the company goes public at $30 per share, Jason will have $30,000,000 worth of stock. Because he is considered an “insider” Jason is severely restricted when attempting to sell his stock. He not only has the normal company black-out periods, but also extended black-out periods due to his position. Additionally, Jason does not want to be seen as losing faith in the company when he decides to sell some stock, but does want to take some money off the table. How to handle such a concentrated stock position?
Fluent suggested two approaches. First, Jason enters into a 10b5-1 trading plan. This type of plan allows Jason to sell during the blackout periods. Jason simply enters into the plan when no blackout exists, he then determines how much he wants to sell in the future, at what price, and on what dates. By putting this plan into place, those sales can go through, even during blackouts. What’s more, because he put the plan in place before selling the stock, he cannot be seen as having insider knowledge that caused him to lose faith in the company. He simply is selling 5,000 shares per month every month.
The second approach Fluent took is called an equity collar. Jason is comfortable with the $30 price. At that price he will be able to retire and live the lifestyle that he wants to. To protect that price Fluent constructs an equity collar. They simultaneously sell out of the money call options and purchase out of the money put options on the stock. The put protects Jason from any downside in the market, but comes at a cost. The call option limits Jason’s ability to gain any more money on the stock, but because he receives a premium for this, he is able to pay off the cost of the put option. This is also called a costless collar, or zero-premium collar. Fluent has now locked in the price at roughly $30 per share so that Jason can continue to sell shares without concern about price fluctuations.
Furthermore, because the shares are collared, and are now safe, Jason can borrow as much as 90% of the value of his shares up front. Jason uses some of this money to buy a new house and diversify into other investments.
By working with Fluent through the lifecycle of his shares, Jason has been able to purchase all his stock at very favorable prices up front. He avoided paying taxes on the purchase at a time when he had very little money, he created a plan for selling the stock, secured a good price for the stock, and was able to buy a house and diversify his money. All while working at HPI.