Monday, March 29, 2010

IPOs -- not exactly what they are all cracked up to be

I graduated college during the peak of the Dot com boom.  During this period, you heard of people making millions overnight and becoming set for life.  What you don't hear are what happened to those individuals after the bust.  After almost 10-years since graduation, I finally was able to separate the fantasies from reality.

Let's follow the details of IPOs in a lot more detail and let me explain to you how a real IPO doesn't really make the majority of the employees as wealthy as they would like to believe.

I'm rich... on paper.

This is a very common theme during the Dot com booms.  People were living on borrowed debt secured by their stock on the anticipation of ever increasing stock price value.  Hmmm... this sounds very familiar?  The most recent bust was brought on by people taking equity out of their home and lenders allowing individuals to borrow debt secured by their homes, believing that home value will continue to rise.  History does repeat itself, just in slightly different variations.

Most IPOs lock up employees from selling their shares immediately, this is to give assurances to the institutional investors that there would be minimal fluctuations of the stock post going public.  The lock ups are typically anywhere from 6-months to 1-year.  This means that although your company is going public, you would not be able to cash out on your hard work until much later, and potentially only after a bust.  In addition, the proceeds from the sale can be taxed upwards of 40% as ordinary income unless you have exercised the options for at least 1-year to meet the minimum requirements for long term capital gains (at a more reasonable 15% for 2009-2010).

There are even more potential problems when you exercise your options.  Let's talk about AMT.

AMT... not only for the rich.

AMT is now surprisingly affecting more and more middle class individuals, even though back in the day it was only for the extremely wealthy.  Because this is an additional source of revenue for the Government, it is not likely this will go away.  The risk here is if you exercise too many of your shares too early on, you can potentially hit AMT and loose all of your tax deductions from property taxes, interest paid on your mortgage payments, and other loopholes.

How does this work?  Let's say Company A was nice enough to issue you options of their stock for $1/share and your company just went public for $10/share.  You decide to take advantage of the long terms capital gains and exercise your options now.  Uh oh, you now have potentially $9/share of income on paper that can be counted towards your AMT.  Even though you have not actually seen the proceeds from your transaction (you're holding onto the stock, i.e. paper, not actual cash) you are still liable for the potential proceeds you could have gotten if you did sell your stock right then.

Now if the value of the stocks plummet down to $2/share a year from now, you are still liable for $7/share in taxes.  A lot of Dot com newbies got into this dilemma when they exercised their options to buy shares at the peak of the stock price and were only able to sell the stock when the price plummeted, sometimes to being worthless. IPO and options are never a sure thing.  There is a risk involved as with any other investment. 

I have $100,000 in options, but what is my exercise price (cost)?

I love how recruiters play up the value of the options you will receive.  What's actually important here is the delta between the price where you can buy the share and the price you can sell the share to the public.  If when you exercise the stock you have to pay $90,000 for the options, your true net proceeds is only $10,000.  That's a heck of a lot less than the lucrative $100,000 the recruiter wanted you to believe you will receive. 

You company just had its IPO, you must be rich!  Only if you joined early on.

Think of this as a risk-reward.  The earlier on you join a company, the more options you are likely to receive and at a much lower exercise price.  This is because when the company is just starting, there isn't much value there.  As time progresses and the company continues to prove itself with year-after-year of profit, naturally the value of the stock will improve and as the stocks become more valuable the company will issue less of it.  What is the moral of this story?  This means only the people at the very top (senior management level) as well as people who get in on the company very early will make the most out of their options. Most employees will get "okay" options that may net them a couple thousand dollars.  Better than nothing, but still not good enough to sacrifice your life for a company once you realize how much you really get out of it.

Those quotes from the movie "Boiler Room" and other related films tooting the virtues of "janitors driving a Ferrari" are really just playing into the fiction created by Hollywood.  Like the movie "Wall Street", "Pretty Woman" and "Thomas Crown Affair", Hollywood likes to romanticize certain careers, sometimes to the point where it is so far removed from reality it's funny to most insiders.

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