Recent Unicorn IPOs are Generating Significant Wealth — But Not as Much as You Think…

Samantha Orlan
Apr 24, 2019 · Unlisted

A New Era of Tech IPOs

The San Francisco Bay Area is bracing itself for a serious influx of wealth as some of the biggest technology companies — among them, Uber, Lyft, Pinterest, and Zoom — prepare to go public or have recently gone public.

In addition to the companies listed above, Slack, Airbnb, and Postmates also have impending IPOs. While this is not an exhaustive list of the companies expected to go public, these companies alone are expected to bring a staggering $190 billion in value as they enter the public markets.

Will all the employees at these companies become overnight millionaires?

While most people have been lead to believe yes; unfortunately, it’s not quite that simple.

In this post, we’ll cover some of the complexities with this newfound wealth and how an IPO wealth creation event does not necessarily translate into the overall value of the firm. Specifically, we’ll review:

  1. Constraints with IPO Wealth Creation
  2. Employee Equity Grants are Not Created Equally
  3. Potential Tax Saving for Exercising Equity

Constraints with IPO Wealth Creation

At Windfall, we focus on calculating wealth, or net worth, and understand that the entire process is incredibly complicated. There are a number of factors that point to a more gradual impact than other sources suggest, including: (1) lockup periods, (2) community socioeconomics, and (3) the possibility of an IPO tax.

Lockup Periods

After a company goes public, key investors and employees are “locked up” or are not allowed to sell shares. The lockup period helps the stock price to stabilize by signaling the firm’s quality to investors, aligning incentives, and protecting underwriters. Depending on the offering, these lock up periods are typically between 90 and 180 days. ¹

Given that perceived wealth is tied to the stock price and the valuation at IPO, this doesn’t necessarily mean the individuals who are “benefitting” as a result would really have the same level of wealth within 6 months of an IPO. In fact, as we’ve seen in certain IPOs, the overall wealth level may be significantly lower than what public markets enabled for the IPO.

For example, Snapchat (SNAP) closed its first day of trading up 44 percent from its initial offering price of $17 back in March 2017, and was trading as low as $12 within six months of the IPO.

Impact to the Community

Many times, especially in the Bay Area, analysts look at housing prices as an indicator of wealth. While increasing interest rates have tempered some of the real estate prices in recent months, as employees become more liquid, many predict subsequent increases upon issuing since these newly rich people will want to buy property after renting at exorbitant prices for years and years.

In fact, many academic researchers have been investigating the impact including a November 2018 study “Cash to Spend: IPO Wealth and House Prices”. Their findings indicated that demand for housing would increase upon the S-1 filing and then again when the stock is issued. ²

However, with housing supply continuing to increase in the Bay Area due to the population of aging households and the general lack of affordability, it’s actually quite possible that increased demand for housing will actually drive prices down.

As liquidity becomes more prevalent after lock-up periods have ended, there may be secondary effects for Bay Area residents. According to an opinion article on Bloomberg, “The effect [of increased buying power] may be concentrated in the San Francisco Bay Area, where many of these companies are located, but there will be second-order effects — like retirees selling their homes to tech workers and moving to cheaper pastures — as well as some employees cashing out and moving to other metros where housing is more affordable.” ³

This means that the wealth that we perceive as staying in the Bay Area may have a cascading effect on not only other members of the community but also those that will take their wealth and move to other geographies across the country.

An IPO Tax? Maybe…

Taxes will also greatly impact the speed at which new wealth hits the Bay Area. The Twitter Tax, a payroll tax was levied inside the city limits between Central Market Street and the Tenderloin in order to keep tech companies in the city rather than moving to Silicon Valley, ultimately enabled a portion of the tech boom and flood of wealth to San Francisco and its surrounding area.

With the Bay Area as an example of the wealth gap in the United States, Supervisor Gordon Mar is considering a tax on the wealth generated by the IPOs to reduce the scope of the impact and avoid increasing the wealth gap and affordable housing. ⁴

In 2012, San Francisco reduced the payroll tax from 1.5% to 0.375% through the phasing of the gross receipts tax. According to The Guardian, Mar said, “With the impending IPOs, the tax that they will have to pay to the city will be a fourth of what it would have been prior to what it would have been in 2012 for the stock compensation income.” ⁵

With Mar discussing applying a new payroll tax to stock options, the city could realize substantial funds to put toward affordable housing; however, there is no hearing on the calendar as of yet.

Not All Equity is Created Equal

“They work at [___insert company name___] and it just went public — they must be worth a lot of money now!”

We’re sure you have overheard this from some of your co-workers, friends, or family. While the company has certainly seen financial success, it may not necessarily translate to each employee. Moreover, even if an employee does see an economic “windfall” with their equity in the company, it may not necessarily translate into cash in their pocket. Uncle Sam certainly wants to take his portion of the new wealth.

First a quick disclosure: Windfall is not an accounting firm nor do we provide financial advice. Please consult your tax advisor to determine the best path forward for you.

The type and amount of tax on exercising equity in the public markets will depend on the following variables:

  • Equity vehicle
  • Timing restrictions associated with exercising each type of equity
  • Exercise price based on grant date
  • The hold period between grant and exercise
  • The time between exercise and sale

There are various tax implications associated with exercising options and selling stock after an IPO. The taxes depend on the type of equity compensation the startup provided: incentive stock options (ISOs), non-qualified stock options (NSOs), sometimes both, as well as restricted stock units (RSUs).

Eligibility to exercise is a big consideration. For example, if the current stock price per share is $75 and your strike price is $50, then by exercising your option you can buy and then immediately sell your shares for a $25 per share profit (less applicable taxes, fees, and expenses). However, if your strike price is $75 and the current market price is $50, your options are said to be “underwater.” In this scenario, you would actually lose $25 a share if you bought your options and sold them on the open market!

Timing and ultimately your tax burden — long term versus short term capital gains — is a large factor for someone’s motivations to sell. For example, if someone exercised while their company was still private and then held their stock for a year, they will probably be less concerned about the tax impact as it would be treated as long term capital gains. Whereas, if you wait for your company to go public and exercise and sell your options immediately, you would be subject to short term capital gains. Many employees may not be aware of this and suffer larger tax bills. If they had never purchased the equity prior to the IPO, it may be a fairly large capital outlay to purchase and hold the equity for up a year or more.

The example below illustrates the tax rates for a couple with $100,000 taxable income.

Given the misunderstanding of long term versus short term capital gains, many employees will get stuck in the vicious cycle of having to sell additional stock to cover the tax liability incurred. Upon the sale of your stock, you might fall into a higher tax bracket and become subject to taxes that amount to more than the profit of your sale, forcing you into a position to sell even more stock to pay your taxes.

Charitable Contributions: An Opportunity for New Wealth

As employees look to minimize their tax impact, there are potential ways to minimize the overall burden, including donating to charitable organizations (as long as you itemize your deductions). If employees decide to contribute the stock versus cash, they are still able to take the full deduction versus selling the stock, getting taxed, and donating the remainder to the nonprofit.

An illustrative version of the full deduction is shown below:

Source: Forbes

Summary

Generally speaking, much of the hype around the impending IPOs is exaggerated. No, not all of your friends at Uber and Airbnb will become overnight millionaires (although some probably will). Of the millions of millionaires already in California, the 6,000 people (on the high end) in the Bay Area who might experience a windfall as a result of the IPOs, likely won’t cause much chaos.

The type of equity held, when stockholders are eligible to sell, when they decide to sell, and the company’s performance over time, all factor into how much money will actually be at play.

About Windfall:

Windfall helps you identify, understand, and engage the affluent. We provide you with precise net worth data on affluent US households, allowing you to make informed data-driven decisions.

For more information about Windfall please visit our website: https://www.windfalldata.com.

Sources:

  1. https://www.investopedia.com/ask/answer/12/ipo-lockup-period.asp
  2. Hartman-Glaser, Barney and Thibodeau, Mark and Yoshida, Jiro, Cash to Spend: IPO Wealth and House Prices (November 30, 2018). Available at SSRN: https://ssrn.com/abstract=3329651 or http://dx.doi.org/10.2139/ssrn.3329651
  3. https://www.bloomberg.com/opinion/articles/2019-03-29/tech-ipos-and-u-s-home-equity-will-unlock-enormous-wealth
  4. https://48hills.org/2019/03/could-sf-tax-new-ipo-wealth/
  5. https://www.theguardian.com/us-news/2019/mar/26/san-francisco-ipo-tech-industry-stock-market-new-millionaires

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