Another thing spooking Facebook’s stock: Taxes

May 18, 2012, 10:44 PM UTC

FORTUNE — Add taxes to the potential reasons the social network’s stock didn’t pop in its IPO. The issue is the $4 billion dollars that will be owed by Facebook’s employees as part of their stock windfall in six months. That tax bill is almost certain to lead to a wave of forced selling of at least 100 million of the company’s shares, and quite possibly much more, within the next six months. The risk of all those shares flooding the market was likely a weight on Facebook’s offering.

The reason for the potential wave of selling has to do with an unusual way Facebook (FB) structured its employee incentive program. A few years ago, Facebook shied away from handing out typical stock options to its employees in favor of something called restricted stock units (RSUs). The move dates back to a few years ago when CEO Mark Zuckerberg was still trying to delay taking Facebook public as long as possible. Unlike options, the RSUs were not counted as actual shares. That meant Facebook could hand out the RSUs to its thousands of employees and skirt a rule that would have forced the company to go public when it hit 500 shareholders. But what looked like a smart move back then could hurt Facebook’s shares for the next few months.

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Most IPOs have lock-up periods that bar employees from selling shares for six months. But Facebook’s RSUs may make the end of that lock-up period more dicey than others. That’s because, unlike with options, Facebook employees will owe income taxes on their RSUs whether they decide to sell them or not. And unlike options, there is no incentive to exercise your options and then not sell the stock so that you avoid income taxes and pay lower capital gains taxes. Facebook estimates that on average its employees will be hit with a combined state and federal tax rate of 45% on their RSUs. The result is likely to be a wave of selling in mid-November. The question is what all that tax-induced forced selling will do to Facebook’s stock.

Following its IPO, Facebook had just over 421 million shares available to buy and sell on a daily basis. According to Facebook’s prospectus, the RSUs will add an additional 277 million shares six months after the company’s IPO. Assume 45% of those will be sold immediately, and the number of shares of Facebook in the market could jump by 31% in a short period of time. And that’s if Facebook employees just sell what they have to for taxes. If employees dump their entire stake, the number of Facebook shares in the market could jump by 65%.

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And it’s not just employees who could be selling. Facebook’s largest venture capital investors own an additional 400 million shares. Those firms, too, would be eligible to sell after six months, and because venture capital funds by mandate are typically supposed to have most of their money invested in companies that have not yet gone public, most of those investors will sell as well. Add in all the shares that could possibly hit the market in the next six months, excluding those owned by Zuckerberg, and the number of Facebook shares could more than triple to 1.4 billion.

“There could be a huge number of shares,” says Nathan Drona, an analyst who has tracked Facebook’s IPO at ABR Investment Strategy and written about the float issue. He says the lock-up period is often an issue with IPOs. “Unless the demand suddenly increases for the stock, it’s going to drop.”

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Still, it’s not clear how much Facebook’s stock price could be affected by the additional shares. Facebook’s initial float – the number of shares it’s selling in its IPO divided by its total shares outstanding – is 19%. That compares to just 7% in Google’s IPO. The large initial number of Facebook shares could blunt the affect of the increase. Still, six months after its IPO Google’s float still equaled just over 8% of its out standing shares. Facebook’s float growth, largely because of the RSU tax issue, is likely to be much more dramatic.

Facebook itself seems to be somewhat concerned with the issue. While the company is not likely to pay its employees’ tax bill, the company has indicated that it may buy some or all of the shares its employees have to sell to pay their taxes, rather than have those employees sell those shares on the market. “We anticipate that we will extend substantial funds in connection with [employees] tax withholding,” wrote Facebook in its offering statement. What’s more, the Nasdaq recently changed the rules to allow companies that have only been public for four months to enter it’s Nasdaq 100 index. That’s down from as much as two years. The move was widely seen as made for the benefit of Facebook, which decided to list its shares on Nasdaq instead of the New York Stock Exchange. When companies are added to an index they typically get a boost as funds that follow that index have to buy in.

“There is a long list of people who have to own this stock, and pretty good list of people who have to sell it,” says Kevin Landis, a portfolio manager at FirstHand Funds, which owns Facebook shares. “It’s a hand-off that has to happen. Even a strong stock can have an ugly tape at six months.” And why would want to buy ahead of that?