The story is a familiar one. A couple of people, usually under 30, have an idea for a new high-tech product or service. They toil away amid empty pizza boxes and soft-drink bottles. They work seven days a week, often sleeping at work.

The company is starved for cash and asks employees to take stock and options as all or a major part of their compensation. Then one day, the company goes public and many of the employees are now millionaires thanks to the stock and stock options.

This scene has played itself out too many times to be an isolated incident. Early employees of companies like Microsoft, Netscape, Yahoo!, and others have won the financial lottery of the initial public offering (IPO).

At first it would appear that the road to riches involves finding a high-tech startup and riding it through its public offering. There are, however, three problems with this strategy:

It will help you understand the value of stock options if you have a good understanding of the initial public offering process and what changes for a company.

The story at the beginning of this chapter was common in the late 1990s. The last three years of that decade saw an unprecedented number of IPOs, many in the high-tech sector. But you certainly don't have to be a high-tech company or even a new company to make an IPO. In early 2000, United Parcel Service—a 90 year-old company—made its IPO.

There are a number of reasons private companies choose to go public, including

Although employee ownership is sometimes cited as one of the reasons to take a company public, there are other means to accomplish this goal. We'll look at some of them in Lesson 13, "Employee Stock Purchase Plans," and Lesson 14, "Employee Stock Ownership Plans."

The IPO process is a complicated legal and marketing experience that is not within the scope of this book. However, a quick summary is in order to set the rest of this chapter in the proper context.

An IPO changes the essential nature of the corporation from one with few owners and little reporting requirements to one with many owners and complete disclosure of every facet of the company.

Private companies, for the most part, can keep their books closed to the outside world, while public companies must disclose any fact that may impact the price of its stock. For example, if any senior officers leave or have health problems, the company reports that information to the public.

Investors and stock analysts study public companies thoroughly. Any weaknesses are noted and estimates are made on future earnings and stock prices.

This "fishbowl" exposure is the price companies pay for the right to sell their stock in the public markets.

The Securities and Exchange Commission (SEC) governs IPOs. The SEC overseas the nation's stock exchanges and protects consumers against stock fraud and manipulation. The agency recommends securities laws to Congress and enforces existing ones.

Most of these rules apply to the company; however, regular employees who receive stock or stock options before or after an IPO may find some of these rules affecting their freedom to take advantage of the IPO. These rules may inhibit your freedom to sell stock or exercise options. I deal with stock in Lesson 13.

Some of the obstacles you may face do not come from the SEC, but from the underwriters of the IPO. They have reasons for restricting the sale of stock or exercising of options that I explore in the following sections.

I spend an entire chapter on this subject in Lesson 12, "Options and the Private Company," but for right now, I want to walk through the transition from private options to publicly traded stock.

One of the major problems facing private companies that want to grant stock options is placing a value on the stock. If it is not publicly traded, there is no ready market to set a value on the stock.

Assuming the company is planning to do an IPO in the future, the company can grant options in the anticipation of the public offering, which will create a fair market price for the stock.

The options can be nonqualified stock options, incentive stock options, or a combination of both. Most employees will receive nonqualified stock options (NSOs).

If the options are granted a significant period of time before the IPO, they can be priced very low without running into problems later on. Options granted close to the IPO must conform to the same conditions we discussed earlier in Lesson 8, "Exercising Your Options."

For example, NSOs granted close to the IPO should not be discounted more that 10 percent, while NSOs granted much earlier can be severely discounted without getting the company in trouble with the authorities.

Underwriters are the firms that make the initial sales of the IPO stock to retail stock brokerages. They take responsibility for the success of the IPO and impose restraints of their own.

For example, employers frequently grant options that have a lockup period (as discussed in Lesson 4, "All About Vesting, Lock-Ups, etc.") or restrict in some way an employee's freedom in regards to options. The lockup period can be anywhere from six months to more than a year. During this time, you can't exercise your options even if you plan to hold the stock.

The underwriters do not want employees exercising options and selling stock just when the underwriter is trying to sell the public on the company. The underwriters fear investors will wonder why they should buy the stock when employees are selling.

This can cause some frustration within the company. Employees may be holding vested options worth a lot of money granted long before the IPO, but they can't do anything with them.

There is more bad news. It was not uncommon in the late 1990s for high-tech IPOs to skyrocket in price the first few weeks. The bad news is that many IPOs fail to hold that value for long.

You may be in the unfortunate position of holding options that are declining in value every day after the IPO and you are unable to exercise them due to a lockup period or vesting.

Some companies have watched their options drop in value to the point of being "out of the money" or, in other words, worthless. This is not a good way to motivate employees.

A solution is to reprice the options. This strategy simply says that an option with a strike price of $35 per share is now an option with a strike price of $20 per share.

Employees love this solution, but investors are usually not happy with it. After all, no one gives them a second chance in the market.

Of course, not all IPOs lose value. The story at the beginning of this lesson is proof enough that even with the restrictions, you can make money with your options.

The good news is you can make a lot of money. The bad news is you may owe a lot of taxes. The previous Lessons 9, "Taxes and Options," and 10, "Taxes and Your Options," on taxes made the convincing case that planning is important when exercising options.

This is doubly true when exercising deep discount options after an IPO. As mentioned earlier, your company may grant you options long before the IPO. If it does it far enough in advance, the discount might be steep. It is not unheard of for companies to grant early options for less than $1 per share.

For example, you have options on 1,000 shares of stock with an exercise price of 25¢ per share. The company makes its IPO and after the lockup period, you are free to exercise your options. The fair market value of the stock is $35 per share.

Your spread is $34.75 per share. If you exercise all 1,000 shares, you will owe withholding tax on $34,750. Since the tax could easily be 20 percent, your tax bill is almost $7,000. On top of that, you may trigger an alternative minimum tax.

Some companies arrange to help employees handle big tax bills like this. They may offer loans with the stock as collateral or other helps, but you must pay the withholding tax.

If you do a cashless transaction, you will have the cash even though it will take a big chunk out of your profits.

It may make more sense to use some of the planning strategies noted in Lessons 9 and 10, such as delaying the exercise or exercising in increments. Your employer may make some tax planning help available to you.

Professional help will cost some money, but may save you more than it costs over time. It is always wise to consult a tax expert when dealing with large sums of money and potential tax problems.