Early Expiration of Startup Stock Options - Part 1 - A $1 Million Problem

Stock Option Counsel, P.C. - Legal Services for Individuals.  Attorney Mary Russell counsels individuals on equity grants, executive compensation design, employment agreements and acquisition terms. She also counsel founders on their personal interests  at incorporation, financings and exit events. Please see this FAQ about her services or contact her at (650) 326-3412 or by email.

The startup scene is debating this question: Should employees have a full 10 years from the date of grant to exercise vested options or should their rights to exercise expire early if they leave the company before an IPO or acquisition?

This is Part 1 of a 3-part series. See Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution and Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage

EARLY EXPIRATION PERIOD

The standard in the past has been that startup stock options are designed with this early expiration period. They must be exercised by whichever comes first:

1. 10 years after the date of grant or

2. 3 months after the last date of employment.  (We’ll call this an “early expiration period.")

If a stock option is not exercised by this deadline, it expires and the individual forfeits all rights to the equity they earned. In some cases, this period is shorter, such as expiration 1 month after or even the day of last employment.

If an employee leaves a startup - by choice or involuntary termination of employment - and has to exercise stock options within an early expiration period, he or she has the following choice:

1. Pay the exercise price and tax bill with savings or a loan;

2. Find liquidity for some of the shares on the secondary market (which is complicated, not widely accessible, and sometimes prohibited by company or law) to pay for the cost of the exercise price and tax bill; or

3. Walk away and lose the vested value.

A $1 MILLION PROBLEM

This can be a $1 million problem for employees at successful companies because the tax bill due at exercise is based on the value of the shares at exercise. Either ordinary income or alternative minimum taxable (AMT) income may be recognized at exercise. This income will equal the difference between the option exercise price and the value of the shares at the time of exercise. The value of the shares is usually called fair market value (FMV) or 409A valuation.  These values are generally set by an outside firm hired by the company. The company may try to set these valuations as low as possible to minimize this problem for employees, but IRS rules generally require that the FMV increases with investor valuations and business successes.

The more successful the company has been between option grant and option exercise, the higher the tax bill will be. For a wildly successful company, the calculation might look like this:

Here’s an example:

Exercise Price = $50,000

FMV at Exercise = $4 million

Gain (either Ordinary Income or AMT Income) Recognized at Exercise = $3,950,000

Hypothetical tax rate = 25%

Taxes Due for Exercise = $1,027,000

Total Exercise Price + Tax Cost to Exercise = $1,077,000

REMEMBER: FMV at exercise is not cash in hand without a liquidity event. Therefore, if the option holder in this example makes the investment of $50,000 plus the tax payment of $1,027,000, they might never realize the $4 million in stock option value they earned, or even reclaim the $1,077,000 exercise price + tax. The shares may never become liquid and could be a total loss. For someone who goes into debt to exercise and pay taxes, that might mean bankruptcy. So, even if they can come up with $1 million to solve the early expiration problem at exercise, they may have wished they had not if the company value later declines.

Investor-types frame this as a simple investment choice - the option holder needs to decide whether or not to bet on the company by the deadline. But many people simply do not have access to funds to cover these amounts. It’s not a realistic choice. The very success of the company they helped create makes it impossible to exercise the stock options they earned.

Although these numbers may seem impossibly large, I regularly see this problem at the $1 million + magnitude for individual option holders. The common demographic for the problem is very early hires of startups that grew to billion-dollar valuations.

WHY NOW? LATER IPOS, HIGHER VALUATIONS, MORE TRANSFER RESTRICTIONS

Early expiration of stock options is a hot issue right now because successful startups are staying private longer and staying private after unprecedented valuations. These successful but still private companies have also been enforcing extreme transfer restrictions.  These longer timelines from founding to IPO, higher valuations between founding and IPO, and transfer restrictions are causing the early expiration of stock options to affect more employees.

1. Later IPOs = more likely early expiration applies before liquidity. The typical tenure of a startup employee is 3-4 years. As companies stay private longer, employees are more likely to leave a company after their shares have vested but before an IPO. If they have to exercise within the early expiration period but before an IPO, they must pay taxes before they have liquidity to pay the taxes.

2. Higher valuations = higher grant prices. Exercise prices for stock option grants must be set at the fair market value (“FMV” or “409A Value”) of common stock on the date of grant. If an individual joins a company that has had some success in raising funds and in business, the FMV at grant will be higher. Therefore, departing employees are more likely to have hefty exercise prices to pay within an early expiration period. With delayed IPOs they are unlikely to have access to liquidity opportunities to cover exercise prices.

3. Higher valuations = higher tax due at exercise. Total tax bills at exercise are more likely to be high as the company valuations are high because taxable income (either ordinary income or alternative minimum taxable income) is generally equal to FMV at Exercise - Exercise Price. With delayed IPOs, employees are unlikely to have access to liquidity opportunities to cover tax bills.

4. Extreme transfer restrictions = no liquidity prior to IPO or acquisition. In the past, private company stock could be transferred to any accredited investor so long as the seller first offered to sell the shares to the company. (This is known as a right of first refusal or ROFR. The market for pre-IPO stock is known as the secondary market.) Some companies are prohibiting such secondary market transfers and similar structures such as forward sales or loans that had historically allowed employees of hot companies to get liquidity for the shares to pay for exercise costs and tax bills at exercise. Some companies add these transfer restrictions after issuing the shares and even push the limits of the law by claiming that they can enforce new restrictions retroactively.

I hope this post has illuminated the problem of an early expiration period for startup stock options. For more on a solution to the problem, see Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution. See also Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage

Thank You

Thank you to JD McCullough for providing research assistance for this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.

Thank you to attorney Augie Rakow, a partner at Orrick who advises startups and investors, for sharing his creative solution to this problem in Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution.

Stock Option Counsel, P.C. - Legal Services for Individuals.  Attorney Mary Russell counsels individuals on equity grants, executive compensation design, employment agreements and acquisition terms. She also counsel founders on their personal interests  at incorporation, financings and exit events. Please see this FAQ about her services or contact her at (650) 326-3412 or by email.