Paper Millionaires

It’s Not Mega-Yacht Time Yet: How Paper Billionaires Become the Real Thing

Yes, Mark Zuckerberg is no longer phenomenally rich. He’s only fantastically rich, worth in the neighborhood of $14 billion. That is still a huge fortune. Although Facebook stock has taken a beating in its first few weeks on the public markets (down almost 30%), those who bought in cheap before the IPO, like Zuckerberg, have seen their net worth soar. If you paid a buck a share for Facebook, even at $27, you’re making a killing.

From founders to employees, venture capitalists and angel investors, Facebook’s initial public offering has turned thousands of the company’s private stakeholders into very wealthy people. But as you wait to emerge from underwater on your own Facebook stake, here is something to take solace in: Until all those newly minted millionaires have sold their stake and the cash clears, they’re only millionaires on paper (small solace maybe).

Owning a piece of a company doesn’t mean you can buy a yacht tomorrow. Nobody cashes out of Facebook–or any newly public company–until bankers, the SEC, and the IRS say so. So how does a guy like David Choe, the graffiti artist who took stock for payment when he painted Facebook’s first office actually sell his Facebook stock now worth about $140 million? When does he get to create an art installation made entirely of cash?

BRING IN THE UNDERWRITERS

When a company files for an IPO, it hires a syndicate of investment bankers to act as underwriters. Before the public can start investing in a company, the SEC requires that it spill its financial secrets. Underwriters help do the spilling (though as has been alleged in the case of Facebook, it’s not always a completely transparent process). In addition to profiling the company’s financial health and prospects, underwriters set rules for the IPO, and shop shares to potential investors.

“When companies go public it’s kind of like molting. You shed a skin and you start again. A whole new group of people get to know you for the first time,” says Tim Westergren, founder of Pandora, which went public in 2011. Since investors tend to dislike the idea of a company’s core employees abandoning ship as soon as stock starts trading, underwriters impose a temporary “lockup” or no-sell period for existing shareholders.

“A pre-IPO shareholder of a company that goes public generally cannot sell their stock until the company’s IPO lockup period expires, which is normally 180 days,” says Barry Silbert, founder and CEO of SecondMarket. “After that, shares are freely tradable on the public markets.” Meaning: Zuck and the gang’s FB shares could flood into the market¬–and Ferrari dealerships–as early as mid-November.

Depending on the health of the stock after the lockup, shareholders sometimes prefer not to sell immediately. Cornerstone OnDemand, for example, a cloud computing company that went public last March, has grown revenue 52 percent since its IPO. It’s stock has barely budged in aftermarket, however.

Perhaps waiting for a bit more of a return on their investment, some of Cornerstone’s original venture capital investors are holding onto the stock despite the lockup period expiring. “When a company goes public it’s not like a VC fund automatically unloads all of its shares,” says David Haber, a partner at law firm Lowenstein Sandler. “It’s really determining how and when to maximize value for the limited partners (the investors in the VC fund).” Although some VC’s do it as a matter of practice, it’s generally considered bad form to bail on your company as soon as the lockup period expires. “We didn’t have a big cash out moment at the end of the lockup,” Westergren says of Pandora. “There’s been a pretty orderly and very gradual selling of stock because everybody has a very long-term view of the business.”

AN OPTION TO BUY

Selling, however, requires you own actual stock, rather than simply possessing stock options. So before dropping the down payment on that yacht, a stock optionee must buy their stock.

Stock options are the right to buy a certain amount of stock at a certain price, but you still have to buy them. Where Facebook fortunes get made is the difference between the price people with stocks options pay for stock, determined when options were granted, and the current price everyone else is paying.

For example, if an early Facebook employee was granted stock options when the company was private, and stock was valued at $1 per share, the employee could buy his or her shares for $1 each (or sell that option on the secondary market for someone else to buy). The employee then turns around and sells them after the lockup for whatever the current stock market price is, say today’s price of $27.

But the reverse also works if share prices drop after an option is granted. There are likely Facebook employees, and investors who bought shares in the secondary market before the Facebook IPO, that have at least some options underwater like the rest of us–worth less today than the price at which they were granted.

Once the lockup is over, and options have been converted into stock, cashing out is relatively easy: Call a stock broker and tell him or her you want to sell. However, depending on how long someone has held shares, the IRS could swoop in to claim as much a one-third of the dough. The amount of Uncle Sam’s take depends on how much a shareholder wishes to delay gratification, as well as the type of stock options he or she holds.

WHERE’S MY YACHT?

Here’s the part where you may want to consult an accountant. There are two main types of stock options: Incentive Stock Options (ISOs), which can be taxed at a lower rate than Non-Qualified Stock Options (NSO). If an ISO stockholder sells shares after holding them for less than a year, the money earned is taxable as income, which could be 30% or more for big IPO winners. But if the stockholder hangs onto their shares for more than a year before selling, it counts as capital gains, taxed at 15% (soon to be more if Bush’s tax cuts expire). That’s why venture capitalists, such as early Facebook-backer Accel Partners, argue against counting their income from the appreciation in value during a sale or IPO of one of their portfolio companies as anything other than capital gains.

Much of the time, Haber says, people sell their stock immediately so they can afford the cost of exercising their options in the first place. But those who want the 450-foot mega yacht like Larry Ellison over some sissy 40-footer, often scrape up the funds some other way to buy options and wait out the first year–if they have faith in the stock. Since the Facebook lockup is still in force, it will be interesting to see come November how much faith insiders have.

NSOs are taxed as income on the difference between the option purchase price ($1 in the earlier example) and the sale price ($27 in the earlier example). Holders only get the lower, capital gains tax on anything they make in the stock market after that. So, if prices go up to $30 – and the stockholder hangs onto the shares for the requisite year – $3 per share gets taxed at 15%, and the rest is taxed as regular income.

More @ http://www.wired.com/business/2012/06/its-not-mega-yacht-time-yet-how-paper-billionaires-become-the-real-thing/