When Selling IPO Stock, Don’t Let Taxes Stand in Your Way
After an IPO, it's time to divest and diversify as efficiently as possible. Don't let the fear of taxes prevent you from making a smart move. Here's why.
Three years after the offering, the median IPO stock underperformed by 18% as compared to a diversified Betterment portfolio with 90% stocks.
Factoring in the value of tax deferral, the median still underperforms by 16%.
At Betterment we have one foot in the investment world and another in the tech world. We often are asked questions about what our entrepreneurial customers should do with their equity after a liquidity event, like an IPO.
First, I tell them congratulations. I know how hard everyone works to earn equity in a company, whether employee or investor. Second, I tell them to diversify. Why? By holding onto a single stock, you dramatically increase your chances of losing money. Lastly, I talk to them about taxes. While they are always top of mind, our statistical analysis shows that the median IPO stock still underperforms substantially, even when factoring in the taxes you’re likely to pay when selling.
IPO stock: Pop, then flop
Jay Ritter of the University of Florida, a leading researcher on the short-term and long-term performance of IPO, looked at IPOs during 1970-2010 and compared the post-IPO stocks to similar listed stocks; Ritter found that the equal-weighted returns for the IPOs were -4.8% for the first year, -8.1% through the second year and -3.3% through the first five years.
Ritter’s research also shows that the vast majority of the return from an IPO stock happens on the first day. This ‘pop’ as it is known in the industry, can be engineered to be very large—a controversial practice which largely benefits the underwriter and its institutional clients—at the expense of the company doing the offering. In any case, an employee with equity is typically blocked from selling immediately after the IPO, and has no choice but to be exposed to the first few months, pop or not.
However, once listed, the company is subject to intense public scrutiny, earnings estimates and the emotional swings of the market. So the question is, does holding post-IPO stock for the medium to long-term make sense? The answer appears to be a resounding no.
That brings us to selling and taxes.
Irrational tax aversion is no excuse
It is true that selling post-IPO stock likely means realizing taxable capital gains. There are some valid tax-related considerations here. Avoiding short-term capital gains is always a top priority, so the key is to start the clock ticking to qualify your holdings as long-term as soon possible (by exercising your options, for instance, if that’s your scenario). Triggering substantial capital gains in a single tax year could bump you into a higher tax bracket—a consideration you may need to balance against the desire for expedient diversification by spacing out your sales. But note that these considerations are about avoiding additional tax liability. The aversion to realizing long-term capital gains which are unavoidable (if you ever plan on utilizing this wealth) needs to be tackled head-on: it should not be a blocker to optimal diversification.
To put the perceived benefit of tax deferral in perspective, we re-ran the same analysis, this time factoring in the impact of a 15% capital gains tax that would accompany the switch into a diversified portfolio. To do this, we assumed a position (say $100) that for simplicity was 100% built-in long-term capital gain. Then, for each post-IPO stock, we compared performance over three years of (a) $100 invested in that one stock, followed by a 15% tax on the entire amount at the end of the period, against (b) $85 (pay tax on day one) invested in the diversified portfolio, then just the gains taxed again at 15% at the end of the period.
Essentially, the question we asked is – does holding onto that $15 for 3 years and having it invested (before you have to give it away) make up for the poor average performance of the un-diversified asset? Not even close. Paying the upfront tax reduced the margin negligibly: the median post-IPO stock still underperformed by 16% (versus the 18% before taking tax deferral into account). Moral of the story: don’t let aversion tax prevent you from making a smart long-term wealth building move.
A simple, mechanical plan for selling
Another point where too many people get hamstrung is waiting for exactly the right moment to sell, ostensibly when the price is at the highest. This is market timing—potentially even riskier than trying to time the market as a whole. Of course, only you know your own specific situation. But generally, prudent finance means developing a plan to eliminate, or at least dramatically reduce, your single stock position in around a year (e.g., selling up to 10% per month over 10 months). The risk is, of course, that your pricing might be suboptimal in hindsight. Nobody can predict the future, but as this analysis shows, you are more likely to be pleased with your decision than to regret it.
The bottom line
With investing, an important consideration for building long-term wealth is to be diversified and avoid concentrations of holdings, especially at the company for which you work (in this case, your portfolio and your salary are too closely correlated).
This is especially true if new stock represents the bulk of your net worth, where a sinking share performance means a greater proportional loss to your wealth. Big believer in your company’s prospects? Great. So are lots of people in the public markets, who will happily pay you the market value for your stock. (Earlier this year, I wrote about the impact of tech holdings on your overall diversification strategy.)
Or think about it this way: not selling has the same effect as buying. Would you liquidate all your other holdings and spend all of your available cash to buy even more of your company’s stock at the expense of diversification? If not, why hold onto it?
While certain tech IPOs garner a lot of attention, hundreds of other IPOs take place each year. Whether or not you’re working at a company that grabs headlines, the strategy post-IPO is the same: Spread your risk.
But transitioning wealth from a single holding into a diversified portfolio is just the first step to building long-term net worth. Managing a diversified portfolio is the second. That’s what Betterment does for you efficiently. We automate every step of investment management with sophisticated software, from asset allocation to automatic rebalancing to tax optimization.
The end result is that you’re able to invest for the future with peace of mind.
1We’ve updated our pricing structure since this article was published. Learn more at betterment.com/pricing.
Cash Analysis Methodology
Betterment's cash analysis aims to provide smart feedback when we think you have extra cash that could be earning you more value if it were in a higher yield account.
Should I Own Stock in the Company Where I Work?
Buying a company stock at a discounted price can also be worthwhile—if you remember to diversify as soon as possible.
How Does Betterment Calculate Investment Returns?
Understanding and using time-weighted and money-weighted returns within your Betterment dashboard.
Explore your first goal
This is a great place to start—an emergency fund for life's unplanned hiccups. A safety net is a conservative portfolio.
Whether it's a long way off or just around the corner, we'll help you save for the retirement you deserve.
If you want to invest and build wealth over time, then this is the goal for you. This is an excellent goal type for unknown future needs or money you plan to pass to future generations.
How would you like to get started?
Your first step toward a smarter investing future starts here.
Create a Betterment account
Go ahead and join the smart, modern way to invest.
See what we can do for you
Tell us a bit about yourself, and we'll show you the benefits of investing with us.
Get a free investing checkup
Help us get a sense of your investing approach and see how you could improve.
Transfer a 401(k) or an IRA
Move an existing retirement account into a Betterment IRA.
Download the mobile app
Enjoy the Betterment experience anywhere on the go.