The Unfair Stock Option Exercise Period

startup advisor compensation

Stock options are a fabulous compensation tool for early-stage companies that can’t typically afford to pay market rate salaries. They also serve as a good retention tool for employees that have unvested options.  That’s because they desire them to vest in order to maximize the value of their equity during a future exit event.  But there’s something about most stock option plans that seems unfair to me – the 90-day post-termination exercise period.

For more information about early stage employee compensation, see my article titled “Founder & Employee Compensation When You’re Cash Poor

Background

Stock options are just that, an option to purchase (aka – exercise) a given quantity of stock in the future, but at a fair market value (FMV) price set when the options were granted.  In the early days of a startup, the exercise price can be in the pennies per share or even a fraction of a penny.  If the startup later goes public or is acquired for $10 per share, the option holders stand to make a lot of money.

For more information about setting the FMV for your stock, see my article titled “Pricing Your Stock in the Early Days

Stock options have a vesting schedule that makes the full quantity of stock gradually exercisable over a period of time.  The most common vesting schedule is four years, although I see some pre-revenue startups set a five or six year vesting schedule.

If an employee resigns or gets fired, any vested stock options must be exercised within what’s referred to as the post-termination exercise (PTE) period.  This PTE period is defined in the employee incentive plan (aka – stock option plan) and it has traditionally almost always been 90 days.  That is because the IRS assigns much less favorable tax treatment to stock options that are exercised more than 90 days post-termination.  Instead of getting incentive stock option (ISO) tax treatment, they are treated as “non-qualified”.  This means that instead of not having to pay taxes until the exercised options are actually sold, the departed employee has to pay taxes on the difference between the exercise price and the FMV at the time of purchase.  That’s right, even though the employee didn’t actually sell the stock for a cash gain, they still have to pay taxes on the amount of on-paper profit.

The Unfairness

Employees aren’t required to exercise the stock options after they leave the company.  But if they worked long enough to actually vest some or all of their stock options, shouldn’t they still have the chance to reap the rewards if the company goes on to do great and wonderful things?  They might have joined when the company’s future was still risky or when the company could only pay them half of the market-rate salary.  No problem, you might say, if they feel the company still has solid future potential, they should just exercise their vested stock options after they depart the company.  Hold that thought.

After a startup starts generating repeatable revenue and certainly after they raise a real equity round of funding like a Series A, their stock option exercise price significantly escalates.  Rather than pennies per share or less, it might be a dollar or more.  The total cost to exercise the vested stock after departing the company could be in the thousands or tens of thousands of dollars.  That’s a really big check to write for a lot of employees.  Is it fair that the most significant determining factor for exercising stock options post-termination is someone’s net worth or available cash on hand?

You might be thinking about scenarios in which an employee is terminated for fraud or sexual harassment.  What about scenarios in which they relocated to another city with their spouse, decided to go back to school to get their master’s degree, or just gave birth to their third child and decided to be a stay-at-home dad?  If they busted their ass and were a solid employee, shouldn’t they stand to gain if the company they helped build goes on to great success?

Confessions

I have to admit a couple of things.  As a former company executive and still-active board director, I enjoy seeing stock options returned to the option pool after an employee departs and decides not to exercise their vested options.  This recycling of stock means a longer period of time until the company will need to true-up the stock option pool with more shares.  That means less dilution to me and the other current equity holders.  Guilty as charged.

I also have to admit that it took a recent debate with a startup founder and some research to understand a movement that is just getting underway to help me realize the unfairness described above.  Guilty as charged.

Finally, I have to admit that every equity-compensated advisory board or board director assignment I’ve taken in the past 15 years came with a requirement to grant me 10-year exercise rights from the date of original grant if my service ever terminated.  I required that solely due to the potential tax hit I would experience if I were otherwise forced to exercise my vested options within 90 days of service termination.  Guilty as charged.

The Solution

In a nutshell, the solution is simple.  Extend the post-termination exercise period as a standard right in the stock option plan.  Give the employees a lot longer than just 90 days to make an exercise decision, both for purposes of coming up with the needed cash and for accommodating the potential tax hit.  There are a handful of nuances you’ll need to decide, but to my way of thinking, this is the solution to the unfairness problem.

What about the employee retention benefit the 90-day PTE provides the company?  After all, if employees don’t have the cash to exercise their stock and they feel it will be worth a lot of money someday, they might stick around instead of leave.  Well, I have two responses to that.  First, I don’t want employees just hanging around.  I want them fully dedicated and driven by the company’s mission.  Second, once employees are on the downhill slope of vesting (especially as they enter the fourth year), I believe the company should evaluate them for additional stock option grants.  That adds to the unvested share quantity, which recharges the retention incentive.  Departed employees will continue to have their equity percentage diluted as a result of fundraising activities and option pool true-ups, but remaining employees that get periodic top-ups of stock options are able to offset some of that dilution, which is a deserved reward.

Carta has been writing about this issue for a few years and has some interesting features in their own solution to accommodate the solution (see a recent article from them here).  I also found a list of companies that have already jumped onto a more fair bandwagon (you can see it here).  The list has about 60 companies as I publish this article and I’m sure there are lots more than are shown on the list.  Regardless, I’m certain the full community of companies doing something like this will be ten times longer in a couple of years and 100 times longer within five years.

The Nuances

Vesting Period

I don’t know where the typical four-year vesting period originally came from but I’ve seen theories that it was from a time when companies went public much quicker than they do today.  Regardless, I think adding the significant benefit of an extended PTE period could easily be accompanied with a longer vesting period, such as 5 – 6 years.

Eligibility for Extended PTE Period

Much like the 1-year cliff vesting period that is common (no vesting until the 1 year anniversary, then an immediate catch-up vest), I could see requiring new employees to earn their extended PTE period.  Maybe they have to reach their 1 yr or 2 yr anniversary in order to get this special term.

You could also decide that termination for cause wipes out the extended PTE benefit – either all “for cause” types or just especially egregious ones like fraud, theft, sexual misconduct and violence.  You’ll definitely want legal advice if you decide to pursue this as I’m sure the definitions are important.

Length of PTE Period

One option is to just select a period of time, like 5 yrs or 10 yrs.  To be clear, this means 5 yrs or 10 yrs from the option grant date, not from the employee’s termination date.  There is another IRS provision that imposes a 10 year expiration from the option grant date.

Another creative approach that further promotes retention is to tie the extension to years of service.  In other words, maybe at two years of service the employee becomes eligible for a 2 year PTE period.  Each additional year of service adds another year of PTE, up to a maximum of 10 years.

Summary

Matters such as those described in this article take some real soul searching for the founding team.  What sort of company culture do you want to foster and how does something like this fit with that culture?  (see my related article titled “Founding Principles – Do You Have Them?“)

Furthermore, anything related to decisions about equity-based compensation is important enough to closely involve your corporate attorney and certified accountant.  Don’t just download some online templates and copy/paste.  You want to do this by-the-book (see related article titled “Accumulated By-the-Book Debt Will Eventually Come Due“).

Don’t binge read my whole blog, just order the book!!!

Dramatically improve your odds of fundraising success by reading my book titled Startup Success: Funding the Early Stages of Your Venture. It leverages my knowledge from making more than 200 early stage investments and from raising more than $80M in private and venture capital.

Learn More

“Startup Success is so actionable that I immediately started applying the concepts as I read. After reading the book, I now have a plan of attack with a very high level of confidence and certainty.” (Ramon Berrios, CEO, Trend)

“Whether you’re a first-time founder or have already raised millions from VCs, Startup Success is a book you want close by before hitting the fundraising trail!” (Andy O’Hara, Founder & CEO, Chiron Health)

Want Notifications When I Post New Material?

Either select the preferred method on the top-right side of this page or complete the form below.

Leave a Reply