Understanding the post-termination exercise period for stock options is crucial for tech startup founders, advisors, board directors and early-stage venture investors. In this comprehensive guide, you’ll gain valuable insights into creating fair and motivating stock option plans that drive employee excitement and retention.
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 employees 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 and, increasingly, others. 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“
Quick Background on Stock Options
Stock options are just that, an option to purchase (aka – exercise) a given quantity of stock in the future. But the purchase price is the fair market value (FMV) set when the options were granted. In the early days of a startup, your exercise price can be in the pennies per share, or even a fraction of a penny. If your 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 Option Vesting Period
Stock options have a vesting schedule that makes the full quantity of stock gradually exercisable over a period of time. This feature presents a great retention incentive for employees, as long as the startup is doing well.
By far, the most common vesting schedule is four years. Although, I increasingly encounter fresh-starting and pre-revenue startups with a five or six year stock option vesting schedule. These startups typically plan to switch to the traditional four-year schedule once they get their product launched or raise a real seed round of funding.
A “cliff” vesting period is incorporated into most stock option plans. No vesting occurs until the cliff date is reached. The cliff period is almost always 1 year. On the cliff date, there is a catch-up in vesting, as if the options had been vesting all along.
Post-Termination Exercise Period
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). 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, if they were exercised within 90 days of termination, they are treated as “non-qualified” in the eyes of the IRS. That means 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.
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. And maybe their reason for leaving had to do with a personal or family-related matter. 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.
The Stock Option Exercise Price Rises over Time
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 a fraction of a penny per share or less, it might be $0.50 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 for a lot of people to write, especially with only 90 days to do it.
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?
Reasons for Departure
You might be thinking about scenarios in which an employee is terminated for cause. You don’t want to do anything special for them. But 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 for years, shouldn’t they stand to gain if the company they helped build goes on to great future success?
I have to admit a couple of things. As a multi-time company executive and a still-active board director, I enjoy seeing stock options returned to the option pool. This happens each time 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 fully 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.
Solution for a Fair and Exciting Stock Option Plan Feature
In a nutshell, the solution is simple. Extend the post-termination stock option exercise period as a standard right in the stock option plan. Give the employees longer than just 90 days to make an exercise decision. This helps address the issue 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 on. But to my way of thinking, this is the solution to the unfairness problem.
Affecting the Retention Incentive
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, you don’t want employees just hanging around. You want them fully dedicated and driven by the company’s vision and future potential.
Second, once employees are on the downhill slope of vesting (especially as they enter the final year of vesting), I believe the company should evaluate them for additional stock option grants. That adds to their unvested share quantity and with a new vesting timeline. That, in turn, recharges their retention incentive.
Departed employees will continue to have their equity ownership 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. That seems like a deserved reward. The same often happens when employees are promoted to a higher level.
I’m Not the Only One That Feels This Way
Carta has been writing about this issue for years. They even have some interesting features in their own offering to accommodate the solution. Read a recent article from them here. I also found a list of companies that have jumped onto a more fair bandwagon. You can see that here. The list had about 60 companies when I first published this article and now there are almost 200. I’m certain the full community of companies doing something like this will be ten times longer in a couple of years. And I hope it becomes standard practice within ten years.
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. Perhaps 5 – 6 years, especially for pre-revenue or early revenue startups.
Eligibility for Extended PTE Period
Much like the 1-year cliff vesting period that is commonplace, I could see requiring new employees to earn their extended PTE period. Maybe they have to reach their 2 yr anniversary in order to get this special term.
You possibly should also decide that termination for cause wipes out the extended PTE benefit. Perhaps due to all “for cause” types, or just the 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 alternative 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. If the employee doesn’t complete an exercise within 10 years of grant, the stock options evaporate!
Another creative approach that further promotes retention is to tie the extension to month of active service. In other words, at 12 months of service the employee becomes eligible for a 12-month PTE period. Each additional month of service adds another month of PTE, up to a maximum of 5 years. The reason I didn’t say a maximum of 10 years is due to the IRS issue. An employee that is granted stock options, works 5 years before departing, would only have 5 more years on the IRS 10-year clock for required exercise.
Make sure to talk to your accountant about the way expenses are accrued for outstanding equity awards. An extended PTE policy might increase your expenses each time an extension is granted to an employee. Fortunately, that should be a non-cash type of expense.
Matters such as those described in this article take some real soul searching for the founding and executive team. What sort of company culture do you want to foster? 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“).