What You Should Know About the IPO Lockup Period

IPO lockup is a period of time following an IPO or SPAC acquisition during which pre-IPO shareholders are prohibited from trading their shares. A lockup agreement may also limit the number of shares that a pre-IPO shareholder can sell within a certain period of time. Lockup periods are not mandated by the SEC; however, pre-IPO startup companies and their underwriters typically require them. If you hold pre-IPO shares in your company, understanding how the lockup period works is critical for developing a strategic tax and financial plan.

The lockup period and its associated rules are established in the underwriting agreement, which insiders must sign before the company may move forward with IPO. If parties to this agreement violate its terms by trading or attempting to trade shares before the end of the lockup period, they may be subject to fines or other consequences at the company level. Each underwriting agreement contains its own specific terms, so make sure that you understand the provisions of yours.

When lockup of pre-IPO shares is preceded by a special purpose acquisition company (SPAC) acquisition, then the duration of the lockup period is negotiated between the SPAC and the acquired company. When a company enters the public market via SPAC acquisition, some of the shares of the existing company that the SPAC purchases are held by existing shareholders. Some of these shares may become immediately liquid upon acquisition.

In some cases, an IPO can involve several lockup periods with different expiration dates. This is most common among larger companies whose executives own a substantial proportion of shares. A series of lockup expiration dates can allow different groups of employees to begin selling their pre-IPO shares at different times.

What happens to the price of stock during the lockup period depends on a number of factors. In general, however, it’s common for the price of a stock to fall as pre-IPO shareholders begin selling and the supply of shares on the public market increases as a result. Because many public investors understand this dynamic, the share price may actually begin to decline a few days before the lockup period expires as investors anticipate this price drop.

To avoid unpleasant surprises, it’s vital that you understand from the beginning how and when you’ll be taxed on your investments. Company stock comes in a variety of forms, including restricted stock units (RSUs), restricted stock awards (RSAs), incentive stock options (ISOs), nonqualified stock options (NSOs), and qualified small business stock (QSBS). Each type of stock is treated differently by the IRS. Since tax rules can be complex, it’s important to work with a tax advisor who is well versed in employee stock and the IPO process to develop a tax strategy. Be sure to understand what type (or types) or stock you’ll be receiving as well as when they will vest.

One way you can manage your tax liability is by taking control of when tax is applied to your gains. An investor who receives shares that are subject to forfeiture, including ISOs and RSAs, may be able choose to pay taxes on their shares of company stock early, before they vest. This is done by making an 83(b) election. An 83(b) election must be filed with the IRS within 30 days after receiving the restricted stock.

This tactic can be immensely beneficial in the event that the share price later skyrockets, since the value of the investment will be much lower at the time it’s taxed. On the other hand, if an investor’s stock value takes a dive after they make an 83(b) election, this can result in tax overpayment, since no tax refund is available in this event. This is an inherent risk in filing an 83(b) election, making it important to get the advice of a trusted fiduciary investment advisor before making your decision.

An 83(b) election makes ISOs taxable at the time of granting rather than at the time they vest. In the case of ISOs, an investor must exercise their stock options early in order to take an 83(b) election. Not all companies allow this, so if ISOs are part of your compensation plan, find out whether it’s an option for you. Stock options represent the right to purchase company stock at a specified price. When you early exercise, you purchase the shares of stock, meaning you must pay for shares well before you’ll be able to sell them. This, of course, requires some financial planning.

Rather than options to purchase company stock, RSAs are grants of company stock that are subject to a vesting schedule, which typically spans several years. Normally, the value of these stock awards is taxed as shares vest. When a recipient of RSAs makes an 83(b) election, however, they are taxed on the value of the shares at the time the election is made rather than at the time that shares vest. Since the share price of a successful company can be expected to increase over time, locking in the value of those shares early for tax purposes can have obvious benefits.

Working with a tax professional to complete annual tax projections will help you plan for the bumps and dips in income that can accompany equity compensation. One of the great benefits of tax projections is the ability to determine when and how the alternative minimum tax (AMT) will apply to your tax return. The AMT is an alternative tax calculation that eliminates particular tax preference items (including gains from stock options) in order to insure that high-income taxpayers pay at least a certain amount of income tax. A tax advisor who is knowledgeable about equity compensation can help you plan for the AMT and develop strategies to avoid unnecessary tax liability.

If you receive compensation in the form of restricted stock units (RSUs), it’s essential for tax planning purposes to understand your RSU triggers. Single-trigger RSUs generally vest gradually over a period of four or five years. Shares are treated as ordinary income as they vest, spreading the tax burden over this vesting period. Because paycheck withholding is often insufficient to cover this burden, however, you may need to adjust your withholding rates to avoid a large tax bill at the end of the year.

Double-trigger RSUs, on the other hand, can vest all at once, creating a large income bump—and, consequently, a large tax liability, in a single year. This is because reaching a time-in-service milestone is only the first vesting trigger for these RSUs; the second is a liquidity event such as an IPO or SPAC acquisition. An experienced tax professional who understands the IPO process can help you plan ahead for this event.

One common strategy for limiting tax liability is tax loss harvesting. This involves selling off shares of stock that have lost value and replacing them with similar investments in order to offset gains on other investments. Used properly, this strategy can improve overall after-tax gains on investments. Used improperly, however, it can result in IRS penalties; so, be sure to work with an experienced investment advisor. While many stockholders practice tax loss harvesting just at year’s end, active tax loss harvesting provides greater precision by capturing losses as they occur.

As your wealth grows, so does the complexity of managing your tax liability. It’s smart to consult with a wealth management professional about gifting and advanced estate planning strategies that can limit the tax implications of gains that result from selling your shares. Various types of trusts can be used to support your favorite charities as well as pass wealth to heirs while providing tax benefits and, in some cases, a stream of income, for you.

Before you can enjoy gains from your company stock, you’ll most likely incur substantial costs, including the share purchase price, taxes, or both. Often, holders of stock options and pre-IPO shares owe taxes on these benefits before they realize any gain from them (for example, when an 83(b) election is filed or when restricted shares vest before the lockup period has expired). This is another reason it’s critical to plan ahead with a tax professional. You may be able to take out a loan to cover your tax liability as well as any purchase price you must pay for company stock.

Another tool that startup employees frequently use to access some of the value of their shares is a prepaid variable forward (PVF) contract. In this arrangement, a holder of vested shares makes a sale agreement with a brokerage to be completed in the future. The buyer gives the seller enough cash to exercise their options plus pay the tax from the exercise. However, since the value of the future shares is unknown, the contract is considered open for tax purposes, so the taxes on gains from the sale are not due until the contract is settled, or as soon as the shares become available for transfer.

When the contract reaches its maturity date, the seller delivers either a number of shares predetermined in the contract or the stock’s current value at that time in cash. By purchasing stock early, you can push future ordinary income into capital gains, or at least purchase more shares while the company is at a lower valuation. Be aware however, that prepaid variable forward contracts tend to be highly scrutinized by the IRS, so it’s important to work with an investment manager with tax expertise who is knowledgeable about how to structure them appropriately.

While the permissibility of entering into a prepaid variable forward contract during the lockup period is debatable, this is a good time to start thinking about a repayment strategy for any PVF contract that you already have in place. You can choose whether to deliver shares or cash to pay the costs, including interest and lending fees, which are finalized when the shares become transferable at the end of the lockup period.

One of the main problems with receiving equity compensation is that it tends to heavily concentrate a startup employee’s investment portfolio in a single company, exposing them to a high level of risk. As mentioned above, prepaid variable forward contracts can allow for greater diversification. Another way to mitigate your risk of loss is with pooled insurance products. For a relatively low cost, these insurance plans spread the risk of equity losses among various similarly situated participants.

If you hold stock options, then you’ll need to develop a buying strategy. Whether you currently have options or shares of company stock, you’ll also need a sales strategy. The lockup period and subsequent blackout periods that often apply to those who have nonpublic material information about a company can make this more complicated than you might expect.

If you hold incentive stock options (ISOs), consider exercising them early in the year. When you exercise ISOs, the bargain element (the difference between the exercise price and current fair market value) counts as income only for the purpose of calculating the AMT. If the value of this bargain element is high but the stock’s value subsequently tanks, then you could conceivably end up owing more in the AMT than the value of the stock itself.

If you purchase your stock options early in the year, you could remedy this situation by selling the shares that have lost value before the end of the year. This results in a disqualifying disposition of the shares, removing applicability of the AMT. Of course, you will still likely owe taxes, but they will be calculated based on the exercise and final sales price. The gain on sale will be taxed as regular income with no payroll tax owed..

The intrinsic value of a stock option is simple to calculate. It is the difference between the strike price and current market value. The time value of options has to do with how much time is left on the option contract. The more time that’s left for favorable price movement before the option expires, the more value it holds.

Time remaining in an options contract adds value because when you hold options rather than exercising them right away, you preserve the ability to benefit from price increases without the risk involved in purchasing the stock outright.

Because blackout periods often limit the ability of pre-IPO shareholders to trade shares, it’s important to consider the benefits of establishing a 10b5-1 trading plan early in the IPO process. This type of plan allows you to preschedule trades at times when you do not have nonpublic material information about the company. As long as the trades are appropriately scheduled in advance, you will be able to trade your company shares regardless of blackout periods and open trading windows. You may be able to write a 10b5-1 plan during the lockup period, but this is not always allowed.

After the lockup period expires, it can be difficult to determine the best time to sell shares. You don’t want to miss out on profiting from price increases, but you also don’t want to sit on your shares as the price tumbles, never to rebound. An experienced investment manager can help you develop a stop-loss selling strategy to protect potential gains while preventing excessive loss. This involves setting prices at which you will sell a certain portion of your shares. For example, if you own stock in your company that is currently valued at $10 per share, you might decide to sell a percentage of these shares if the price drops to $9, then sell more if it reaches $8, and eventually reach a bottom price at which you plan to sell the rest of your holding.