Could an ex-employee of a company find themself stranded with shares they cannot sell (and a tax bill)?

Question

A NYTimes article says

When employees leave start-ups, they often have the opportunity to buy stock that has been set aside for them at a low price. But if their start-ups have been successful, they also need money to pay taxes that will be levied on the increased value of the stock.

On this site JoeTaxpayer wrote

You got out of the company just in time. For whatever reason, the stock drops to $21 and at tax time you realize the $1M gain was ordinary income, but now the $800k loss is a capital loss, limited to $3000/yr above capital gains. In other words you have $210k worth of stock but a tax bill on $1M.

These two scenarios appear to discuss the same risk. One obvious way for the employee to protect themself (in the last example) is to sell the shares on the very day they bought them. Then they will be certain not to be left stranded with a hefty tax bill on shares possibly worth less than the tax bill.

But the same NYTimes article opens by stating that it is within the right of companies to stipulate what employees can do with their shares (actual, not options). I see how a company could add restrictions on stocks while an employee is an employee. But once they leave with shares, whether actual or exercised options, they are entirely free to do whatever they want with the shares. In particular, they can sell them to whomever they choose. Is that accurate or could a company put controls on shares owned by ex-employees, all the way until the potential IPO—restrictions that would bar ex-employees from selling?

Answer 1

they are entirely free to do whatever they want with the shares. In particular, they can sell them to whomever they choose

No.

Restrictions on who can sell when and to whom are a common thing with startups. "Publicly traded" companies are regulated in a much stricter way than private companies, so until the IPO the sales are limited to the OTC markets. But even that can be restricted by bylaws - for example ownership can only be limited to a group of investors approved by the board. As an employee - your grant was approved by the board, but when you come to sell, the buyer was not and the company may not agree to vet them.

Bottom line is that it is not illegal to impose all kinds of restrictions on what the employees can do with their shares, as long as the shares are not listed on a public stock exchange (even after the company goes IPO with one class, other classes may remain restricted).

Answer 2

It would take an unusual situation.

• They exercise certain types of option, which come in as regular income rather than capital gains, and are holding the stock "long" (perhaps they are not allowed to sell because of an insider-trading freeze window; like right before earnings announcements). And then the stock tanks.

• Their company is acquired. They get stock options in their unicorn at $1/share, which blows up to $1000/share right as HugeFirm buys it. Options are swapped dollar-for-dollar for HugeFirm stock (at $250/share) so 4 shares for 1. I heard this happened a lot in the 1999-2000 boom/bust.

And the problem was, this type of stock-option had historically only been offered to $20-million salary CEOs and CFO's, who retained professional legal and financial counsel and knew how to deal with the pitfalls and traps of this type of option. During the dot-com boom, it was also offered to rank-and-file $50k salary tech employees who didn't even know the difference between a 401K and a Roth.

And it exploded in their faces, making a big mess for everyone including the IRS -- now struggling to justify to Congressmen why they were collecting $400,000 in taxes on entirely phantom, never-realized income from a 24 year old tech guy earning $29k at a startup and eating ramen. When that poor guy never had a chance of understanding the financial rocks and shoals, and even if he did, couldn't have done anything about it (since he wasn't a high executive involved in the decisions). And even the company who gave him the package didn't intend to inflict this on him. It was a mistake. Even the IRS dislikes no-win situations. Some laws got changed, some practices got changed, etc. etc., and the problem isn't what it used to be.