With some experts still predicting a recession in the near future, option holders and shareholders at private companies should consider the myriad of challenges and opportunities that an economic slowdown may present. With careful planning and strategic thinking, equity holders can increase their chances of coming out ahead. What follows are a few focus areas for private company equity-holders worried about a potential recession.
Understand Grant Terms and Prepare to Negotiate
Recessions often go hand and hand with layoffs due to cost-cutting. Private company stock options have traditionally been granted with a 3-month expiration period following the end of employment. This means that laid-off employees may find themselves with a limited period in which they must exercise stock options before losing them, often at the very time they’re short on cash to exercise. But over time, companies have become more open to longer post-termination exercise periods, and are sometimes willing to extend option expiration dates in connection with departures.
Employees who are concerned about a potential layoff or considering leaving their company should make sure to review the expiration terms of their option grants and consider trying to negotiate an extended expiration period if necessary. However, it’s important to keep in mind that Incentive Stock Options (ISOs) will be converted to Non-Qualified Options (NSOs) if the post-termination expiration period is extended beyond three months, meaning the equity holder will be taxed at the time of exercise at ordinary income rates on the difference between the current fair market value of the shares and the exercise price. Option-holders should consider their financial resources and constraints, their views on the company’s upside potential, and tax goals in deciding whether to seek an extension, exercise in connection with their departure, or let stock options expire.
Weigh the Pros and Cons of Exercising Options
A recession can foster both unique opportunities and greater risk when it comes to exercising stock options. On one hand, a recession often results in decreased 409A valuations, which can reduce the taxable gain when exercising options. This can be advantageous, but even with lower tax liability, expending financial resources to exercise during a period of economic uncertainty has its risks. In a recession, a company’s future can become more uncertain, and equity holders may find themselves more crunched for cash, making the investment potentially riskier. Therefore, the choice to exercise amidst a downturn requires careful consideration of company prospects, personal capital preservation needs, and potential tax advantages.
Plan for a Liquidity Crunch
During a recession, equity holders may have to contend with both diminished liquidity options and heightened liquidity needs. A downturn can lead to a scarcity of secondary buyers and lower valuations on the secondary market for private company shares. At the same time, equity holders may find it more difficult to bolster resources through personal loans, home equity credit lines, additional work, or other means, limiting financial flexibility. Simultaneously, the layoffs and pay freezes that often accompany a downturn can further compound these economic challenges. It can be prudent to plan ahead for the worst-case scenario. Most experts recommend having a three-to-six-month emergency fund to serve as a financial safety net. It may make sense to buffer that fund before an expected downturn, in order to better weather unexpected expenses without resorting to liquidating valuable equity at inopportune times. Building a financial cushion through increased savings, seeking greater income, or accessing alternative sources of liquidity such as through private stock liquidity transactions, may provide security and peace of mind.
Reassess Asset Allocations
Diversification is a cornerstone of financial management, and recession fears can serve as a good reminder to assess and potentially rebalance portfolios. Over time, asset allocations can become skewed. For instance, option holders may find themselves with a significant portion of their wealth tied up in private company equity. Engaging in liquidity transactions or selling shares to redirect funds to other investments may help safeguard wealth by ensuring that a smaller portion of an equity holder’s wealth is locked up in a single asset that could lose some or all of its value. Diversifying may also allow equity holders to capitalize on promising investment prospects that can emerge amidst the economic challenges of a recession when prices of some assets may be depressed.
As investors debate the likelihood of and brace for a possible recession, strategic planning for equity holders is imperative. Equity holders may better withstand and even capitalize on economic turbulence by consulting with their tax and financial advisors to address option exercise strategies, taxation, asset allocation, and liquidity needs. For equity holders and advisors interested in Liquid Stock’s option exercise or liquidity solutions, reach out to our team today.