Double Trigger Acceleration and Other Change of Control Terms for Startup Stock, Options and RSUs
What does double trigger acceleration mean? It protects unvested shares from cancellation in a change of control by immediately accelerating those shares if the individual is terminated as part of the change of control. Founders, executives and key hires, including employee-level hires at early stage startups, negotiate for Double Trigger Acceleration in their equity grant documents at the offer letter stage.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Originally published June 5, 2018. Updated July 27, 2023.
Change of Control Terms for Startup Stock, Options and RSUs
Startup stock, options and RSUs vest over time. Since they vest over time, some may not be vested when the company has a change of control (aka merger or acquisition). What happens to the unvested shares at change of control? It depends on the fine print in your equity documents.
Founders, executives and key hires, including employee-level hires at early stage startups, often negotiate for Double Trigger Acceleration to protect their unvested shares. Advisors and some founders and rare executives may negotiate for Single Trigger Acceleration so that their shares immediately vest at acquisition. However, these protections are not often negotiable for employee-level hires except at very early stage companies. Their equity will be governed by the general terms of the Plan, which will likely be either an unfavorable Cancellation Plan.
Single Trigger Acceleration
The ideal change of control acceleration term is Single Trigger Acceleration - so that 100% of unvested shares vest immediately upon change of control. Investors and companies often argue against this term because the company may be an unappealing acquisition target if its key talent will not be incentivized to stay after closing. This is especially true for technical talent at a technology company.
Advisors, some founders and rare executives may negotiate for Single Trigger Acceleration if they can make the case that their role will not be needed after change of control. For example, advisors naturally negotiate for Single Trigger Acceleration because their primary role is to advise a company at the startup stage. They would not be necessary after an acquisition as they’ve fulfilled their purpose by that time. Founders and executives sometimes argue for Single Trigger Acceleration based on aligning incentives. For example, I’ve worked with a CFO who negotiated for 50% Single Trigger Acceleration because he was hired with the express purpose of improving the company’s financial position to achieve an acquisition. Those with similar arguments may even negotiate for Single Trigger Acceleration to apply at IPO, which would be a very unusual term but a logical incentive for certain hires.
Double Trigger Acceleration
The next best term is Double Trigger Acceleration, in which unvested equity immediately vests if both of two triggers are met. First, the company closes a change of control. Second, the individual’s service is terminated for certain reasons (most often a terminated by the company without Cause or a voluntary resignation by the individual for Good Reason).
Founders, executives and key hires, including employee-level hires at early stage startups, negotiate for Double Trigger Acceleration in their equity grant documents at the offer letter stage.
The key argument for Double Trigger Acceleration is based on risk. If an individual at any level of the organization is taking a significant risk to join the company, such as sacrificing significant cash or other compensation elsewhere to join, they advocate for Double Trigger Acceleration to protect their upside in the event that the equity becomes valuable. A grant of 1% with Double Trigger Acceleration is more valuable because of that protection of the upside. A second key argument for this term is based on “aligning incentives.” If individuals on the team could lose valuable unvested equity by achieving a prompt acquisition, their incentives would not be aligned with the company’s goals of closing that deal. Double Trigger Acceleration rights bring the individuals' incentives in alignment with the company's goals.
This Double Trigger Acceleration protection is negotiated at the offer letter stage and included in the final equity grant documents. The key negotiable terms in this clause are:
Full acceleration so that a qualifying termination at any time after acquisition accelerates 100% of unvested shares;
Application to a qualifying termination in anticipation of, or for a certain protective period of time prior to, change of control;
Application to terminated by the company for Cause (narrowly defined, not to include arguable performance terms);
Application to a resignation by the individual for Good Reason (defined broadly to include a change in cash compensation, a reduction in duties or reporting structure, a geographic change, and anything else that would amount to constructive termination for the individual);
A broad definition of change of control including a sale of substantially all the company’s assets;
Immediate vesting at closing of the change of control if unvested shares would otherwise be cancelled without payment under a Cancellation Plan term. More on this here from Cooley:
Often overlooked, however, is that in order for double-trigger acceleration to be meaningful, the option grant or equity award must actually be assumed or continued by the acquiror in the transaction. This will not always be the case in a transaction – aquirors often have their own plans and ideas for incentivizing their employees. If an unvested option or equity award terminates in connection with a transaction, then technically, there will be no unvested options or awards to accelerate if the second trigger (i.e., the qualifying termination) occurs after the transaction.
Continuation Plan
If the startup’s Equity Incentive Plan includes a continuation term, the value of the unvested shares continue to vest after change of control so long as the individual stays in service after the closing. We’ll call this style of plan a Continuation Plan. The unvested shares are likely to be converted into another form, such as RSUs in the acquiring company or cash deal consideration. But the value is protected so that the deal value per share paid to vested shares at closing will be paid to these unvested shares on each subsequent vesting date. If the individual is terminated or resigns for any reason, they would not be paid out. If the deal does not provide for such continuation or substitution, unvested equity will be accelerated so that it becomes 100% vested and paid at closing.
If an employee's total number of shares was worth $200,000 at the acquisition price, and only 50% had vested at the acquisition, the employee would be paid $100,000 at closing. But the unvested shares would be replaced with a substitution or continuation award in exchange for the $100,000 in unvested value. That might be in the form of cash to vest over time, continuing awards in the original company, or new equity in the acquiring company's equity. Whatever the form, it would continue to vest over the remaining portion of the original vesting schedule.
Without the Double or Single Trigger Acceleration protections described below, the individual could be terminated for any reason, at any time, and would lose the unvested shares. However, those who stay at the acquiring company under a Continuation Plan will continue to earn the deal consideration for their unvested shares. (But beware. Those with unvested equity under a Continuation Plan may also be asked to sign new employment agreements forfeiting these rights as part of the acquisition, since the company’s leverage of termination is significant).
Cancellation Plan
Most startup Equity Incentive Plans allow the company to cancel unvested shares without payment in an acquisition. We’ll call this type of plan a Cancellation Plan. Under a Cancellation Plan, unvested equity can be cancelled and replaced with $0, even if the unvested shares had significant value at the time of the acquisition. For example, if an employee's total number of shares was worth $200,000 at the acquisition price, and only 50% had vested at the acquisition, the employee would be paid $100,000 at closing. The unvested value of $100,000 could be cancelled without payment even if the employee stayed on as an employee after the acquisition. In another example, if the employee was within the first year of service and had a one-year cliff vesting schedule, 100% of the grant could be cancelled without payment even if it was immensely valuable based on the deal price/share.
The distinction between a Cancellation Plan and the more protective Continuation Plan is not usually a negotiable term. The exception to this would be at a startup with employee-friendly founders and executives who are willing to advocate for changes to their Plan with the board and stockholders. When startup candidates encounter this term in their offer negotiation document review, their best course of action is likely to be to negotiate for Single Trigger Acceleration or Double Trigger Acceleration for their individual grants.
Negotiating Change of Control Terms
The availability of Single Trigger Protection or Double Trigger Protection and/or the distinction between a Cancellation Plan and a Continuation Plan is a factor in assessing the risk of joining a startup. If the fine print protects 100% of the unvested shares, the shares have a higher potential upside for the employee or executive. Without these protections, it may make sense to negotiate for a higher cash package or a higher number of shares to balance risk. Check out more on my blog about market data for startup equity offers and other key terms that affect the risk of startup equity including clawbacks and tax planning for stock options.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
VIDEO Startup Stock Options: Startup Valuation
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Startup Stock Options | Post Termination Exercise Period | Examples of Good Startup Equity Design by Company Stage
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Originally published August 11, 2017. Updated March 17, 2023.
It’s helpful for startup employees to understand early expiration of stock options and the possible solution of a full 10 year post-termination exercise period. But the full 10 year term stock option is not the right design for every startup equity grant! In some cases it would be the wrong ask, and pushing for it can can lead to embarrassment or a disadvantageous design.
Examples of Good Startup Equity Design by Company Stage
I work with individual clients to balance their priorities for investment timing, tax timing, tax rates and value structure. These are some examples of how the trade-offs are made at each stage. You can also read more about option exercise strategies here in the Menu of Stock Option Exercise Strategies.
1. Earliest Stage - Startup Restricted Stock Purchase
While a startup is in its early stages and its Fair Market Value (FMV) is quite low, consider purchase of Restricted Stock for founders and early employees. This is the model used for Founders’ Stock at startups, and it is also ideal for executives and employees who are willing to pay the FMV of the common stock up-front for their shares. With the use of an 83(b) election with the IRS, Restricted Stock purchase provides for tax deferral until sale of stock, favorable capital gains tax rates at sale of stock, and fewer tax penalties than stock options in the event the IRS determines the FMV was underpriced for the shares.
2. Early to Mid-Stage - Early Exercise of Startup Stock Options
For those who are willing to take early investment risks for tax deferral and lower tax rates, consider early exercise of stock options. This is an obvious choice for early-stage startup hires who can afford the stock purchase price at hire. For example, at a very early stage startup an employee’s total exercise price might be less than $1,000. Early exercise may also be a good choice for some individuals at mid-stage startups with somewhat higher exercise prices or even later stage startups with high growth potential, as an early investment may be worth it for future tax savings and/or tax deferral.
Early exercise stock options can be exercised before vesting. If they are exercised before the FMV rises above the exercise price, tax payments are deferred until sale of stock by use of a Section 83(b) election at the time of purchase.
However, the investment risk is real, as the purchase price is delivered up-front and shares are held as an investment. If the shares were to become worthless, the investment amount would be lost for both vested and unvested shares.
Early exercise stock options are preferable to restricted stock if the employee is not sure about making the investment up-front. Unlike the purchase of restricted stock, the choice to exercise stock options (even with early exercise rights) can be deferred for some time. However, if the exercise or early exercise is made after the FMV has gone up, the exercise will lead to taxable income.
The early exercise structure can be combined with an extended exercise period (see below under #3 or more here on the blog), so that the employee has the choice between early exercising to minimize tax rates or deferring exercise until any time within the full 10 year term.
Note that the right to early exercise can be a disadvantage for stock option grants with an exercise price greater than $100,000 if they are not early exercised. Any amounts over $100,000 would be ineligible for ISO status due to the ISO rules’ $100,000 limitation.
3. Early to Mid-Stage - Stock Options with Full 10-Year Exercise Period
While there is still potential for high growth in value, stock options are an advantage for employees. However, a high exercise price or a high tax bill at exercise can make it impossible for employees to take advantage of the value of stock options. This is because stock options have traditionally been granted with a disadvantageous early expiration term requiring exercise within three months of an optionee’s termination date. Therefore, stock options are most advantageous where they are granted with a full 10 year term to exercise regardless of the date of termination. This allows the optionee to defer the investment decision and the associated tax bill for exercise.
Additional consideration: Optionees who take advantage of an extended exercise period (exercise their options after 90 days from last employment) lose their Incentive Stock Option (ISO) tax treatment. Shares exercised after 90 days from last employment will be treated as Non-Qualified Stock Options (NQSOs) and generally come with a higher tax rate. However, with this extended exercise design, optionees can choose to exercise within 90 days and keep their ISO classification, or wait to exercise and accept the NQSO classification. This flexibility is key in rewarding optionees of all types and financial circumstance.
4. Later Stage - Restricted Stock Units
Employees may prefer RSUs to stock options at later stage companies for both tax deferral and offer value purposes. Well-designed RSUs defer taxes until liquidity so long as it is within a certain time frame (such as 7 years from the date of grant). RSUs are less advantageous for tax rates, though, as the value of the shares is taxed as ordinary income at settlement. RSUs are advantageous from an investment perspective because there is no investment risk as there would be in a stock option exercise prior to liquidity. RSUs also give the employee the full value of the shares at liquidity as there is no purchase price to pay for the stock as there would be with a stock option exercise price. For this reason, a grant of RSUs generally consists of fewer shares than a grant of stock options at a company of the same stage.
Wrapping Up
This is Part 3 of a 3-part series on the startup scene’s debate about early expiration stock options. See Early Expiration of Startup Stock Options - Part 1 - The $1 Million Problem for more information on the issue and Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution for more information on the full 10-year term solution.
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.
Thank you to JD McCullough for edits to this post. JD is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Startup Stock Options | Post Termination Exercise Period | The Full 10-Year Term Solution
Startup stock options often come with a standard 3 month-post termination exercise period. An option exercise extension can save you from a $1M problem. Photo by olia danilevich.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Originally published March 28, 2017. Updated March 17, 2023.
Startup Stock Options and the $1M Problem
The startup scene is debating this question: Should employees have a full 10 years from the date of grant to exercise vested startup stock options or should their rights to exercise expire early if they leave the company before an IPO or acquisition?
This is Part 2 of a 3-part series. See Early Expiration of Startup Stock Options - Part 1 - The $1 Million Problem for more information on the issue and Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage.
Full 10-Year Term Solution
Some companies are saving their optionees from the $1 million problem of early expiration startup stock options by granting stock options that have a full 10 year term and do not expire early at termination. The law does not require an early expiration period for stock options. Ten years from date of grant is usually the maximum exercise period, as the legal landscape for stock options makes anything beyond a 10 year exercise period impractical in most cases. The 10 year exercise window (without an early exercise period) enables employees to wait for a liquidity event (IPO or acquisition) to pay their exercise price and the associated taxes. This extended structure is designed to compensate employees in a way that makes sense for them.
Startups who choose a full 10-year term in place of early expiration may do so because their recruits or founders have faced the problem of early expiration at prior companies and become disillusioned with stock options as a benefit. Or their recruits may have read about the issue and asked for it as part of their negotiation. Or their founders may have designed their equity plan to be as favorable to employees as possible as a matter of principle or as a recruiting tool.
Other companies are extending their early expiration period for existing stock options. One example of this is Pinterest, which extended the term in some cases to 7 years from the date of grant. This move was in response to their valuation and extreme transfer restrictions that made the early expiration period burdensome for option holders.
An exercise more than 90 days after the last date of employment changes tax treatment for options originally granted as Incentive Stock Options (ISOs). Such an exercise will be treated as the exercise of a Non-Qualified Stock Option (NQSO) instead. Most employees would prefer to have the choice that an extended exercise period allows, the choice between exercising within 90 days of termination of employment for ISO treatment or waiting to exercise and being subject to NQSO treatment.
You can see a list of companies that have adopted an extended option exercise period or changed from the short early expiration period to longer periods.
Current State of the Market as of 2023
Carta’s State of Private Markets for Q4 2022 shared their data on the number of options expiring in that quarter with an extended post-termination exercise period. They report that:
Employees owning 17% of all terminated options in Q4 2022 were given longer than 90 days; and
Employees exercised just 32% of their vested options before expiration during Q4
This is an increase - in my view - from the date of the market on this point in 2017 when I first wrote on this topic. However, it still leaves many startup option holders without an extended post-termination exercise period and makes exercise planning and thoughtful offer negotiation on option rights essential for startup employees and executives.
Creative Modifications to the Full 10-Year Term Solution
Companies may prefer early expiration of stock options because terminated stock options reduce dilution for other stockholders. Or they may prefer that their employees are bound to the company by the “golden handcuffs” of early expiration stock options as a retention tool.
For companies that are concerned about excessive dilution, it might make sense to eliminate early expiration only if the company’s value has increased since grant. In other words, employees have a full 10-year term only if the FMV of the common stock on the date of their departure is greater than the exercise price of the stock option. This targets the solution (tax deferral) to the problem (owing tax at exercise before liquidity). If the FMV at exercise is equal to the exercise price, then there is no taxable income to report at exercise. Therefore, an extended exercise period is not necessary to defer taxes until liquidity. This solution does not address the problem of high exercise prices; companies with high exercise prices due to high valuations may want to use RSUs instead of stock options to solve the exercise price problem.
Attorney Augie Rakow, a former partner at Orrick advising startups and investors, has another creative modification to the full 10-year term solution. He has advised clients to find a middle ground by extending exercise periods only for longer-term contributors. This addresses the company concern about retention while solving the early expiration problem for longer-term employees. For example, option agreements might allow three years to exercise after departure only if an employee has been with the company for three years. He notes that "it's a good solution for companies that want to let long-term contributors participate in the value they help create, without incentivizing employees to leave prematurely."
Can I Realistically Exercise the Options if the Company is a Success?
Due to the prevalence of early expiration stock options at startups, this becomes an essential question in evaluating an equity offer: “Can I realistically earn the value of vested equity if the company is a success?” If the option grant has a very high exercise price or could potentially lead to a huge tax bill at exercise, it may not be feasible to exercise during an early expiration period at the end of employment, making the value of vested equity impossible to capture. Clients have negotiated the removal of early expiration or other creative structures to solve this problem if it arises in the employment offer.
I hope this post has illuminated the usefulness of a full 10-year term as a solution to the problem of early expiration of startup stock options. For other alternatives to structuring startup equity, see Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage. See also Early Expiration of Startup Stock Options - Part 1 - A $1 Million Problem for more information on the issue.
Thank you!
Thank you to JD McCullough for editing this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.
Thank you to attorney Augie Rakow, a former partner at Orrick advising startups and investors, for sharing his creative solution to this problem.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Startup Stock Options - Post Termination Exercise Period - A $1 Million Problem
Negotiating a startup stock option offer? An option exercise extension can save you from a $1M problem. Photo by Pixabay.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Originally published March 28, 2017. Updated March 17, 2023.
Early Expiration for Startup Stock Options
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 called a post-termination exercise period or PTEP.
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. See also The Menu of Stock Option Exercise Strategies for more on option exercise planning and startup offer negotiation.
The standard in the past has been that startup stock options are designed with an early expiration period. They must be exercised by whichever comes first:
10 years after the date of grant or
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:
Pay the exercise price and tax bill with savings or a loan;
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
Walk away and lose the vested value.
Startup Stock Options’ $1M 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 former partner at Orrick advising 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.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Part 3: FAQs on the Menu of Startup Stock Option Exercise Strategies
Wondering when to exercise stock options at a startup? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake. Photo by Kaboompics.com.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
When to exercise stock options?
Thanks for the great feedback on this post: The Menu of Stock Option Exercise Strategies. I’m delighted that people are using it to plan their startup stock option exercise strategies at the offer negotiation stage to save themselves from the unhappy surprises associated with startup stock options.
I’ve had some great questions on the menu and wrote this Q&A in response. Enjoy!
Why don’t you talk more about Incentive Stock Options (ISOs)? The recruiter told me not to worry about my startup stock option exercise at hire because the options are ISOs.
Founders, recruiters, human resources employees and hiring managers often use the “ISO status” of startup stock options to obscure this issue and falsely reassure hires to get them to sign offer letters without a viable option exercise strategy in place.
There are some benefits to Incentive Stock Options. These are relevant if you are following the exercise as you vest strategy or the exercise at termination of employment strategy. The basic difference is that gains on exercise of ISOs are taxed at AMT rates and exemption amounts rather than the ordinary income rates that apply to NSOs. However, this ISO benefit does not change the fundamental risk associated with startup stock options: If the FMV increases dramatically during your employment, the tax cost to exercise can make exercise impossible even with ISOs! More here on this $1M problem.
Why do I need to plan for this at the offer letter stage? Wouldn’t the company want to “help” me avoid forfeiting my vested startup stock options by extending the post-termination exercise period if I leave the company?
The post-termination exercise deadline is not often changed after hire. If an individual does not have (or press) the negotiating power before they join to inspire the company to extend that deadline, in the vast majority of cases they will not have that power at the time of termination or resignation.
My clients often hear founders declare at hire that their companies could not possibly extend the post-termination exercise deadline in the original option contract. In the next breath, those founders promise that their companies would “of course” extend it in the event of a termination or resignation. This is not, in my experience, a realistic promise.
Why? The “company” in this context is the venture capitalists who likely control its board of directors or the law firms who protect their interests. The post-termination exercise deadline is, from their perspective, a feature not a bug. When companies make offers, they assume that only a small fraction of vested options will be exercised (in large part because of these early termination features). Since this is part of the venture capitalists’ economic calculus and method of maximizing returns for their investors, they’re not in the business of helping people out of it.
Why do I need to plan for this at the offer letter stage? The company promised they will let me sell some of my equity stake each year through a tender offer.
You will almost certainly not get a written commitment from a company for a right to pre-IPO sales. Access to an employer-sponsored tender offer will depend entirely on a company’s decision to arrange it, investor interest to fund it, and a company’s decision to let any individual take part in it.
When tender offers are available, they are almost always limited to some small percentage of vested holdings. Given this limited liquidity, most people who have the opportunity to sell a portion of their shares in a tender offer do not use the funds to exercise the remainder of their options. They could, but they do not.
Why? Once those funds are in the bank, these individuals immediately start to think of the funds as “my money.” It seems to them too risky to take funds that they want to use today to buy a house or diversify their portfolio and invest those funds in the exercise price and associated tax bill to exercise their remaining options.
This is a personal choice, not right or wrong. I’m offering it here to show what I have seen as a common phenomenon. Individuals are faced with the problem of a huge expense in front of them to exercise their vested options and pay the taxes associated with the exercise. What happens in practice is that if they do successfully cash out some of their shares, they keep the money and are left with the remainder of their options still subject to forfeiture. Then they encounter this forfeiture problem when they either (1) are subject to option early expiration at termination of employment termination or (2) the approach of the end of the original, non-extendable, 10 year term of the option.
Why do I need to plan for this? I’ve heard there are “services” who will help me sell my equity stake on the secondary market or offer me a non-recourse loan to exercise when I get in this situation down the road.
This method is rarely available. Why? A lot of reasons. Here’s a few:
Investor interest is limited to a few choice companies.
Information asymmetry.
Company transfer restrictions (which also apply to loans in most cases).
For those who are able to access these sources of pre-IPO liquidity, in spite of these and other challenges, they only operate as a “service” for those who have time and other good choices on their side. Those who are caught without time and other good choices will see offers of deal terms that are obviously made with that vulnerability in mind. Calling this market an option exercise strategy would be like calling a payday loan a monthly budget.
Happy strategizing!
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
The Myth of Startup Employee Equity
Working for a startup? Break through the myth of startup equity to make the most of your equity compensation offer. Photo by Startup Stock Photos.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
The shiny myth of startup equity has incredible power to recruit and retain talent. This is the myth:
If you have any startup equity, and the company is a success, you will be rich!
All startup equity contracts are “boilerplate,” so whatever fine print you sign, you will be rich!
You never have to make an investment in or pay taxes on startup equity until you are already rich!
The duller reality of employee equity conflicts with this myth. Here’s my take on this “reality”:
The number of shares in the original job offer will determine whether the potential upside will balance the financial risk in joining a startup.
The fine print terms affect the potential value of any startup equity offer (especially the consequences of a termination of employment prior to a company exit event).
Standard tax structures for employee equity often require individuals to choose between forfeiting vested stock options and making a significant personal investment in the shares (to cover the exercise price and associated taxes) prior to having access to liquidity for the shares.
Most employees believe the myth, so they do not bother to ask questions and learn more about the reality of their equity offers. In this context:
The shiny myth of startup equity does the job of recruiting and retaining employees without any action on the part of the company. Companies can follow the classic sales advice - “Never give someone more information than they need to make a decision.” - and let the myth fill in the gaps. If they don’t ask, why tell?
Only those few companies with extraordinarily favorable employee equity programs have any incentive to educate their employees to see the difference between their plans and their competitors’ plans. That incentive may be minimal, though, as such an education may even disincentivize employees from joining startups with favorable programs. The reality of even the most favorable programs cannot compete with the myth of magical riches.
Those companies with unfavorable terms in their employee equity programs would have zero incentive to provide such an education. Their financial models could not likely be sustained if their employees were knowledgeable about the terms from the start. For example, one prominent late-stage startup with a 3-month post-termination option exercise deadline relies on a model that only 15% of vested options will be exercised. As my colleague commented, the terms that bust the myth would be a feature, not a bug, for such a company.
I would love to hear that I am wrong in my assessment. I would much prefer to be sharing success stories of company-side equity education programs and explaining why startup companies actually do need to educate their employees in order to effectively recruit and retain them with equity. Please comment below!
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Part 2: The Menu of Startup Stock Option Exercise Strategies
Wondering when to exercise stock options at a startup? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake. Photo by Ali Pazani.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
When to Exercise Stock Options?
Before you accept a startup stock option offer, you will want to have a strategy in place for exercising the options. This will save you from the unhappy surprises associated with stock options, such as forfeiting vested options, golden handcuffs, or unnecessary tax expenses.
There’s not a one-size-fits-all strategy, but there is a menu of choices.
Strategy #1: Exercise Startup Stock Options at Liquidity
The default for most startup employees is to wait to exercise their stock options until the company is acquired or they can sell the shares (such as after an IPO). They simply exercise the options and sell the shares on the same day.
The benefit of this default is that they have no out-of-pocket expense to exercise or pay taxes on the option exercise until they are certain they will have a market to sell those shares. It’s a no-risk choice from that perspective.
One downside of this strategy is that a same-day exercise and sale would tax your gains at ordinary income tax rates.
Another downside of this strategy is a lack of career mobility. At most companies, options expire within 3 months of termination of employment. If you are waiting on an exit event to exercise your options, you may be stuck at the company until that exit event occurs.
If you leave the company voluntarily or are terminated by the company before an exit event, you may be forced into exercising your options prior to liquidity or forfeiting the options when they expire. In addition, options have a final expiration date - usually 10 years from the date of grant. This seems like a long time, but occasionally companies do not have an exit event in this timeframe. This forces the employee to exercise prior to liquidity or forfeit the options when the expire.
One variation of this strategy is to negotiate for an extended post-termination exercise period for the options. If you have, for instance, the full 10 year term of the option to exercise regardless of your termination date, you can use this strategy and still be free to leave the company without forfeiting your options. More on that here.
Strategy #2: Forfeit Vested Startup Stock Options by Not Exercising
Most startup employees do not exercise their options if they leave the company before an exit event because they do not want to invest the exercise price and tax cost and risk losing that investment. Therefore, forfeiture is probably the second most common option exercise choice for startup employees. Why?
All options have a final expiration date, which is usually 10 years from the date of grant. Most options also expire earlier at a termination of employment. The standard is that employees have 3 months after termination of employment to exercise their options. An expiration date is a forfeiture date. If the option that is not exercised before it expires is forfeited and the option holder can never purchase the shares underlying the option.
A private company employee facing an expiring option has to make their investment in the shares before there is a public market for those shares. I call this the $1M problem because I regularly get calls from startup option holders who need to come up with $1M to exercise their options and pay the tax cost of exercise. The exercise price of an option may be quite high in itself, especially for an employee who joins later in the startup’s growth. It is the tax cost of exercising, though, that prevents most startup employees from exercising their options.
Strategy #3: Exercise Startup Stock Options at Expiration, Before Liquidity
Not all startup employees forfeit their options if they leave the company before a liquidity event. Many invest the exercise price and pay the associated tax cost when they leave the company so they can acquire the shares they worked to vest.
The exercise of an option is a taxable event, so the option holder recognizes taxable income based on the difference between their exercise price and the FMV on the date of exercise. That might be taxed as AMT for ISOs or as ordinary income for NSOs. Either way, it can result in tax bills in the millions of dollars for the exercise of a valuable option. More on that here.
The tax on an option exercise is due whether or not there is a market to sell the shares to cover the tax bill. Some people call this “phantom income” or a “dry tax charge,” but it’s very real. I’ve heard horror stories about people losing their homes (and moving in with their in-laws) because they exercised their options and incurred this tax expense but did not have a market to sell the shares. In some cases, those shares later were cashed out at a high value in a company exit event which in the end made the risk of investing the exercise price and tax bill a very wise choice. Sometimes, though, the investment of the exercise price and tax bill is lost, since the shares can end up either being worth less than the exercise price or worth less than the taxable value of the shares at exercise.
To avoid this scenario, some startup hires negotiate for an extended post-termination exercise period for the options. This allows them to follow Strategy #1 - Exercise at Liquidity and also have career mobility to leave the company before an exit event and still take advantage of their options. More on that here.
Strategy #4: Early Exercise Stock Options (Prior to Vesting)
An “early exercise” is an exercise of unvested stock options. You pay the exercise price to the company and file an 83(b) election with the IRS. The shares are still subject to vesting, as the unvested shares can be repurchased from you if you leave the company prior to your vesting dates.
Early exercise of stock options is a popular tax planning maneuver, as it starts your capital gains and, perhaps, Qualified Small Business Stock (“QSBS”) holding periods. This sets you up for the lowest possible tax rates when you sell your shares. It may also help you avoid the tax cost of exercise. If you early exercise immediately after grant, while your exercise price is still equal to the FMV of the shares, you have a $0 tax cost to exercise.
Early exercise stock options are not available at every company, but it is worth considering if it is available to you. It may also make sense to negotiate for the right to early exercise as part of your offer negotiation if it is not offered to you. I have also had clients who ask for this right to be added to their options well after they join the company, especially if the company valuation is about to explode and they want to early exercise before the tax cost would make any exercise impossible.
The downside of early exercise of stock options is investment risk, as you have to pay the exercise price (and, perhaps, some taxes at exercise) out of pocket before you have any visibility into whether the value of the shares will go up. Early exercise is very common and an easy choice at early stage companies where the FMV and, therefore, the exercise price is low. It’s a less obvious choice when the company is at a later stage and the exercise price of stock options is significant.
Strategy #5: Regularly Exercise Startup Stock Options as They Vest
The final strategy is to exercise startup stock options regularly as they vest. This is the least popular but (in many cases) the most favorable strategy.
It’s unpopular because it requires both attention and money, which are both in high demand for startup employees. It’s favorable because it provides for some of the same benefits of early exercise; it starts your tax holding period and allows you to avoid the golden handcuffs that come with unexercised options as the tax cost to exercise increases over time.
The downside of this strategy is, of course, the investment risk of paying the exercise price and tax cost of exercise. There is no guarantee that startup stock will ever become more valuable than your exercise price, or that you will be made whole for the taxes paid to exercise.
How does it work? First, you would need to stay apprised of the current FMV of the company’s common stock and upcoming corporate events that might increase the FMV of the common stock. Since the FMV of the common shares on the date of your exercise will determine the tax cost to exercise, you will need to know this in order to make a thoughtful exercise decision.
Second, you would regularly consider whether or not to exercise your vested options. Most people approach this by meeting with their tax advisor or financial advisor on a regular basis to calculate the expense of exercising their vested stock options. This would be done annually or more frequently if the company is anticipating an event that would increase its FMV. If you have ISOs, this would include an analysis of how many options you can exercise tax-free by staying under the AMT exemption amount. If you have ISOs or NSOs, it would include an analysis of the total tax cost to exercise as well as the financial costs/benefits of exercising.
Finally, you would pay the exercise price and associated tax cost (if any) to exercise the vested options.
Conclusion
I hope this menu inspires you to choose a strategy before you accept a startup stock option offer. It’s worth the time and attention to understand your choices and come up with a thoughtful plan of action before you invest years of your time to earn startup stock options.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Part 1: Why You Need a Startup Stock Option Exercise Strategy
Wondering when to exercise stock options at a startup? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake. Photo by Andrea Piacquadio.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
When to Exercise Stock Options?
Startup stock options can be extremely lucrative or extremely disappointing. The biggest disappointments are not from companies that never succeed, but from employees of successful companies that are not able to take advanteBefore you accept a startup stock option offer, you will want to have a strategy in place for exercising those options. This up-front attention will save you from the unhappy but common surprises associated with startup stock options, such as these recent examples:
Forfeiture at Termination. Sales executive drove sales and company value for four years and was terminated a few months before a $1B company exit. He could not afford the $1M exercise cost (to cover the exercise price and tax cost of exercise) within the 30-day post-termination exercise deadline, so he was forced to forfeit most of his vested options. He made approximately $500K at the exit; his former colleagues with similar equity grants made $10M.
Golden Handcuffs. Early hire at a future unicorn did not early exercise his startup stock options or exercise as they vested. He wanted to leave the company after four years when he was fully vested, but he could not afford the $2M cost to cover the exercise price and tax cost of exercise. Therefore, he had to stay at the company for 3 more years while he waited for an acquisition, frustrated that he was not able to move onto his next opportunity.
Tax Expense. Early hire at a future public company waited to exercise his options with a total exercise price of $5,000 until after the shares became publicly traded. He had to sell the shares on the same day as the exercise to cover the tax expense of exercise. Since he had not held the shares for a year before sale, his gains were taxed at ordinary income tax rates of over 40%. If he had early exercised the options, he would have qualified for QSBS tax treatment on his gains, resulting in 0% federal tax rates and saving him >$1M in taxes.
In the Part 2, you will see the menu for startup stock option exercise strategies to save yourself from these unhappy surprises. In Part 3, you will see a Q&A on FAQs re stock option exercise strategies.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Clawback Clause for Startup Stock - Can I Keep What I think I Own?
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Updated October 19, 2020 for a recent clawback event in the news.
Everyone loves a gold rush story about startup hires making millions on startup equity. But not all startup equity is created equal. If a startup adds a repurchase rights for vested shares (a.k.a. a clawback clause or clawback provision) to its agreements, individuals may lose the value of their vested equity because a company can force them to sell their shares back to the company in certain situations, such as if they leave their jobs or are fired prior to IPO or acquisition. Other examples of a clawback clause are forfeiture (rather than repurchase) of vested shares or options at termination of employment or for violation of IP agreements or non-competes.
Image from Babak Nivi of Venture Hacks, who warns startup founders and hires to “run screaming from” startup offers with a clawback clause for vested shares: “Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully.”
How a Clawback Clause Limits Startup Equity Value
In a true startup equity plan, executives and employees earn shares, which they continue to own when they leave the company. There are special rules about vesting and requirements for exercising options, but once the shares are earned (and options exercised), these stockholders have true ownership rights.
But for startups with a clawback clause, individuals earn shares they don’t really own. In the case of repurchase rights for vested shares, the company can purchase the shares upon certain events, most commonly after the individual leaves or is terminated by the company. If the individual is still at the company at the time of an IPO or acquisition, they get the full value of the shares. If not, the company can buy back the shares at a discounted price, called the “fair market value” of the common stock (“FMV”) on the date of termination of employment or other triggering event.
Most hires do not know about the clawback clause when they negotiate an offer, join a company or exercise their stock options. This means they are earning equity and purchasing shares but do not have a true sense of its value or their ownership rights (or lack thereof).
Clawback Clause “Horrible” for Employees - Sam Altman of Y Combinator
In some cases a stockholder would be happy to sell their shares back to the company. But repurchase rights are not designed with the individual’s interests in mind. They allow the company to buy the shares back against the stockholder’s will and at a discounted price per share known as the “fair market value” or “FMV” of the common stock. As Sam Altman (now CEO of OpenAI) wrote when he was the head of Y Combinator, “It’s fine if the company wants to offer to repurchase the shares, but it’s horrible for the company to be able to demand this.”
The FMV paid by the company for the shares is not the true value for two reasons. First, the true value of common stock is close to the preferred stock price per share (the price that is paid by investors for stock and which is used to define the valuation of the startup), but the buyback FMV is far lower than this valuation. Second, the real value of owning startup stock comes at the exit event - IPO or acquisition. This early buyback prevents the stockholder realizing that growth or “pop” in value.
What is an Example of a Clawback Clause?
Famous Example - Skype Shares Worth $0 in $8.5 Billion Acquisition by Microsoft
In 2011, when Microsoft bought Skype for $8.5 billion (that’s a B), some former employees and executives were outraged when they found that their equity was worth $0 because of a clawback in their equity documents. Their shock followed a period of disbelief, during which they insisted that they owned the shares. They couldn’t lose something they owned, right?
One former employee who received $0 in the acquisition said that while the fine print of the legal documents did set forth this company right, he was not aware of it when he joined. “I would have never gone to work there had I known,” he told Bloomberg. According to Bloomberg, “The only mention that the company had the right to buy if he left in less than five years came in a single sentence toward the end of the document that referred him to yet another document, which he never bothered to read.”
Both Skype and the investors who implemented the clawbacks, Silver Lake Partners, were called out in the press as “evil,” the startup community’s indignation did not change the legal status of the employees and executives who were cut out of millions of dollars of value in the deal.
Recent Example - Tanium, funded by Salesforce Ventures and Andreessen Horowitz, claws back employee shares
More recently, Business Insider reported that Tanium, funded by Salesforce Ventures and Andreessen Horowitz, has forced employees to sell their shares back to the company at FMV after their employment is terminated.
The employees interviewed by Business Insider were not aware of that their contract included this clawback when they accepted their offers. “'Surprised' was my initial reaction," one such employee said. "I had not heard of that happening before. To me it felt like a gut punch. One of the reasons for working for the company is dangling the carrot of eventually going public or eventually getting acquired so employees would monetarily benefit from that.”
How Does a Clawback Provision Work?
Hypothetical Example #1 - Company Does NOT Have Clawback Clause for Vested Shares - Share Value: $1.7 Million
Here’s an example of how an individual would earn the value of startup stock without repurchase rights or clawbacks. In the case of an early hire of Ruckus Wireless, Inc., the value would have grown as shown below.
This is an example of a hypothetical early hire of Ruckus Wireless, which went public in 2012. It assumes that the company did not restrict executive or employee equity with repurchase rights or other clawbacks for vested shares. This person would have had the right to hold the shares until IPO and earn $1.7 million.
This is an example of a hypothetical early hire of Ruckus Wireless, which went public in 2012. It assumes that the company did not restrict executive or employee equity with repurchase rights or other clawbacks for vested shares. This person would have had the right to hold the shares until IPO and earn $1.7 million. If you want to see the working calculations, see this Google Sheet.
These calculations were estimated from company public filings with the State of California, the State of Delaware, and the Securities and Exchange Commission. For more on these calculations, see The One Percent: How 1% of Ruckus Wireless at Series A Became $1.7 million at IPO.
Hypothetical Example #2 - Company Has Clawback Clause for Vested Shares - Share Value: $68,916
If the company had the right to repurchase the shares at FMV at the individual’s departure, and they left after four years of service when the shares were fully vested, the forced buyout price would have been $68,916 (estimated). This would have caused the stockholder to forfeit $1,635,054 in value.
In this hypothetical, the individual would have lost $1,635,054 in value if the shares were repurchased at their termination. If you want to see the working calculations, see this Google Sheet.
No Surprises - Identifying a Clawback Clause During Negotiation
As you can see, clawbacks dramatically affect the value of startup stock. For some clients, this term is a deal breaker when they are negotiating a startup offer. For others, it makes cash compensation more important in their negotiation. Either way, it’s essential to know about this term when evaluating and negotiating an offer, or in considering the value of equity after joining a startup.
Unfortunately this term is not likely to be spelled out in an offer letter. It can appear in any number of documents such as stock option agreements, stockholders agreements, bylaws, IP agreements or non-compete agreements. These are not usually offered to a recruit before they sign the offer letter and joining the company. But they can be requested and reviewed during the negotiation stage to discover and renegotiate clawbacks and other red-flag terms.
What is a Typical Clawback Clause?
For examples of typical clawback clause language, see Part 2 - Examples of Clawbacks for Startup Stock.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Early Exercise of Startup Stock Options
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Planning for your startup stock options? Consider an early exercise of stock options to protect your equity stake from taxes and forfeiture.
Most people learn the hard way about the complexity of exercising stock options at a startup. If you can spare a few minutes of attention, this post will teach you about early exercise - the easy street of startup stock option exercise strategies.
Early Exercise Stock Options
An “early exercise” is an exercise of unvested stock options. You pay the exercise price to the company and file an 83(b) election with the IRS before the options vest.
Early exercise makes you the owner of the shares in the eyes of the company. The shares are still subject to the options’ original vesting schedule, though, as the unvested shares can be repurchased from you if you leave the company prior to your vesting milestones. The repurchase price for unvested shares is usually the lower of your exercise price or the fair market value (“FMV”) on the date of termination.
Early exercise with an 83(b) election also makes you the owner of the shares in the eyes of the IRS. That means you start your capital gains and, perhaps, Qualified Small Business Stock (“QSBS”) holding periods, which sets you up for the lowest possible tax rates when you sell your shares.
Tax Benefits of Early Exercise of Stock Options
If you early exercise while your exercise price is equal to the FMV of the common shares, the exercise itself is not taxable and therefore defers all taxation until you sell the shares and have cash gains to use to pay the taxes.
This may seem like overkill on planning, but the tax bill for a later option exercise can snowball surprisingly quickly and make it impossible to exercise vested stock options. More on this here: Startup Stock Options - Early Expiration - The $1M Problem. Early exercise can, therefore, act as a forfeiture-avoidance strategy as it can defer taxes until sale of stock and, therefore, save people from prohibitive pre-liquidity tax bills for exercise.
When to Early Exercise Stock Options
Since options are granted with an exercise price equal to the FMV on the date of grant, it’s a safe bet to early exercise immediately after grant to be sure you can do so without a tax cost.
The most common approach is to negotiate for the right to early exercise in the grant at the offer letter stage, and then join the company and wait a while before early exercising. This allows employees to get some visibility on the company’s possibility of success and their own fit within the company. So long as the early exercise is completed while the FMV is still equal to the strike price, the early exercise is tax free.
If you early exercise (or exercise vested options) after the FMV has increased above the exercise price (such as after a round of funding following your grant date) you will have taxable income on the difference between the FMV and the exercise price in the year of exercise. (The tax rates depend on whether you are early exercising NQSO or making an qualifying early exercise of ISOs.) This might seem unappealing, as you would of course prefer to defer all taxes until sale of stock. However, some people choose to early exercise even if they have to recognize income on that early exercise in order to be taxed at exercise on the current FMV rather than paying higher taxes on a later exercise based on a higher FMV.
Investment Risk of Early Exercise Options
The downside of early exercising startup stock options is investment risk, as you have to pay the exercise price (and, perhaps, some taxes at exercise) out of pocket before you have any visibility into whether the value of the shares will go up in the future. That’s why early exercise is very common and an easy choice at early stage companies where the FMV and, therefore, the exercise price is low. For instance, a first employee might be able to exercise 1% of the company for, say, $5,000. It’s a less obvious choice when the company is at a later stage and the exercise price of stock options is significant. For instance, some startup stock options packages have a $1M+ exercise price.
Some key hires of later stage startups with higher option exercise prices negotiate for the right to early exercise (or exercise vested options) with a promissory note instead of cash. Instead of paying their significant exercise price with cash, they deliver a promissory note to the company. This is a promise to pay the exercise price at some date in the future. There is some complexity to this to address with your advisor if you are considering this path.
Negotiating the Right to Early Exercise Options
Early exercise is not available at every company. Therefore, if you want to early exercise you will need to negotiate for this right during your offer letter negotiation or after you join the company.
For example, some early Uber employees negotiated to add the right to early exercise to their existing stock option grants. This allowed them to early exercise their unvested options (and exercise their vested options) before the FMV of the shares skyrocketed, so that the tax bill for the exercise was only in the tens of thousands of dollars.
Despite the out-of-pocket cost for the exercise price and taxes, this was a wise exercise choice for a few reasons. First, if they had waited and exercised after the FMV skyrocketed they would have had to pay far more in taxes to exercise - in some cases more than $1M. More on that issue here. Second, if they had failed to early exercise and ended up leaving the company prior to the company’s IPO, they would have had to come up with those astronomical tax payments before they had a market to sell the stock. This is because the company had only a 30-day post-termination exercise deadline and an absolute prohibition on sales of stock prior to IPO. Third, many of these employees purchased their shares while the company was QSBS eligible and then held the shares for the 5-year QSBS holding period. This qualified them for 0% federal tax rates on up to $10M in gains on the sale of their shares.
ISOs v. NSOs and Early Exercise Stock Options
If you are early exercising stock options, it is more favorable to have the options granted as NQSO rather than ISOs. If you early exercise ISOs, you have to hold the shares for two years before sale for long-term capital gains tax rates on your gains. If you early exercise NSOs, you only have to hold the shares for one year for capital gains treatment. Therefore, if you are planning to early exercise immediately after the grant, you will want to ask the company to make the grant as a NQSO rather than an ISO.
If you are not planning to early exercise, you may not want to include the right to early exercise in your documents. That’s because of the $100K limitation on ISOs. ISOs are a tax-favored stock option that are subject to certain limits under the tax code. Only $100K in exercise price of stock options can become exercisable in any given year and qualify as ISOs. So if you have a $400K exercise price grant that is intended to be ISOs, all $400K of the options will be ISOs if you do not include the right to early exercise. If you do include the right to early exercise, all $400K will become exercisable in the first year and so only $100K of the options will be ISOs. The remainder will be NSOs which are less tax favored.
Don’t Forget the Section 83(b) Election
If you early exercise unvested stock options, you file a Section 83(b) election with the IRS within 30 days of the exercise. The consequences of a missed 83(b) election can be very, very unappealing. If you don’t have the attention necessary to follow through on that, don’t early exercise.
When to Exercise Stock Options
As you can see, early exercise of stock options is not the best choice in every situation. To learn about the best structures for a variety of cases, see Examples of Good Startup Equity Design by Company Stage. For a comprehensive analysis of when to exercise stock options, see this three-part series:
Part 2: The Menu of Startup Stock Option Exercise Strategies
Part 3: FAQ on the Menu of Startup Stock Option Exercise Strategies
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Seed Stage Startup Job Offer - Equity Negotiation Checklist
Working for a Startup? Seed Stage Startup Job Offer Equity Compensation Negotiation Checklist. Image from rawpixel.com.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Have a job offer from a seed stage startup? Individuals work for equity at seed stage startups (otherwise known as early stage startups) with the expectation that they will have great financial success if the company itself is successful. That dream can come true, but it depends on taking care of a few key details of the option or restricted stock at the offer negotiation stage. Here’s the Stock Option Counsel negotiation checklist for seed stage startup offer negotiations.
Percentage Ownership. The lore of Silicon Valley is that anyone who joins an early stage startup that is later a huge success will become rich. But if they fail to negotiate a significant number of shares at hire, they cannot expect that the value of their interest at the time of an acquisition or IPO will be impressive. Since being one of the first startup employees is extremely risky, there needs to be enough equity in the offer to balance that risk. I have seen individuals who are disappointed (to say the least) in these situations when they have accepted a below-market equity percentage and assumed that the founders would “take care of them” in the future. With these points in mind, I recommend taking the following steps before agreeing to join a startup:
Negotiate for enough shares up-front to balance the risk in joining the company. This is based on market norms, so do plenty of research among colleagues and advisors to confidently set market-based expectations.
Insist on time-based, not performance or milestone, vesting.
Expect that the equity interest will be significantly diluted and negotiate for enough shares to cover that expectation.
Making it Official. At the earliest stage startups, employees and founders often work for promises of future equity without signing the necessary paperwork to ensure that they have the legal right to that equity. They often start working with vague promises of future grants and “trust” that their business partners will “take care of them” in the future. This is misguided, as the purpose of a stock option grant or any written agreement is to not have to rely solely on the trust you have in any individual person. Since changes in leadership, investors, direction, etc. are guaranteed to happen at some point in time, you need protection from the company not promises from the current leaders. Before signing an Offer Letter or beginning work, I suggest to first:
Ask for a copy of the Form of Stock Option Grant or Restricted Stock Purchase Agreement, along with any other documents referenced therein. Review the terms and negotiate any issues.
Ask the company to confirm that the board will officially make the equity grant promptly after hire.
Board Approval Timing. Early stage startup companies often delay officially making grants to the detriment of their employees. This is due to administrative disorganization, a desire to delay the legal and valuation expenses of making the grant, or even a disagreement among executives and investors about how much equity should be allocated for employee grants. After starting in the role, take the following steps:
Follow up to be sure the grant is made by the board promptly. This should not take more than a couple of months.
Compare the terms of the grant to be sure they are as-agreed during the offer negotiation stage.
Tax Planning. The potential tax benefits to receiving equity in an early stage startup are unparallelled. The structure may allow for tax deferral until sale of stock - which avoids the problem of paying taxes on option exercise before liquidity - and lower capital gains tax rates or even 0% QSBS tax rates on gains. Achieving these tax benefits requires precise design by the company - such as restricted stock or early exercised stock options - and effective execution by the individual - such as the timely delivery of the purchase price and filing of the Section 83(b) election with the IRS. Early tax planning action items are:
Negotiate the tax structure during the offer negotiation stage. The right structure will depend on the stage of the company, so work with advisors if necessary to determine the most desirable structure for your grant.
Take care of the required follow-through to take advantage of the most desirable tax structures.
Legal Terms. Startup employees are sometimes very surprised by the legal terms in their grant years after they have accepted its terms. They might have assumed that they have the right to hold the shares that they have purchased and vested and find out that the company can forcibly repurchase the shares at their termination. Or they might assume that they have the right to earn their unvested shares following an acquisition but find out that they can be cancelled as part of the deal without payment. To avoid these and other unpleasant surprises regarding the legal terms of a grant, take the following steps during negotiation:
Ask for a copy of the Form of Stock Option Grant or Restricted Stock Purchase Agreement, along with any other documents referenced therein.
Review the terms and negotiate any issues before committing to joining.
If the legal terms have unexpected risks, negotiate for more shares or more cash compensation to balance the risk.
Have an offer from a seed stage startup? Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
VIDEO: Founder Restricted Stock Purchase Agreements
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Are you a founder with a restricted stock purchase agreement (RSPA)? Protect your equity stake with change of control vesting acceleration, Section 83(b) election and fine print details.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
The Good Stuff - Continuation Plans - How To Avoid the Juno Drivers' Fate of Cancelled RSUs in a $200 Million Acquisition
If you're negotiating a startup equity offer, ask for the good stuff - a Continuation Plan - or even more favorable single or double trigger acceleration terms. Photo by Erik Mclean.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Bloomberg reported on startup Juno's rescission of driver’s RSU awards in its $200 acquisition by Gett. They reported that Juno promised 50% of founders shares to drivers, but that it appears that the maximum portion of the acquisition price they could have received was 1.5%.
What was the disconnect? A type of startup equity plan - a Cancellation Plan - that can dramatically limit the value of employee equity grants.
Some startup stock plans allow companies to cancel unvested equity in an acquisition without payment for the shares, even if the employees holding that unvested equity stay in service after the closing of the deal. We'll call these Cancellation Plans. (You can read more on all the variations of change of control terms in startup equity offers here.)
The standard for startup stock plans has historically been that unvested employee equity must be continued or substituted in an acquisition rather than cancelled without payment. We'll call these Continuation Plans. This means they must be replaced with either cash or equity awards with the same value as the deal consideration for the shares being cancelled. If they are not replaced for the deal value, their vesting will be immediately accelerated at the acquisition and paid the entire deal price for the vested and unvested shares. The replacement still must be earned over the original vesting schedule, so there's no guarantee of earning the unvested shares without also having single or double acceleration upon change of control protections. However, this traditional requirement offered protection of value for employees. Those who stay at the acquiring company under a Continuation Plan will continue to earn the deal consideration for their shares in some other form.
The Cancellation Plans that allow cancellation of in-the-money unvested equity without payment are grabbing value from employee shares. Unvested equity - RSUs, options, etc. - can be cancelled and replaced with $0. For example, if an employee's total number of RSUs were worth $200,000 at the acquisition price, and only 50% had vested at the acquisition, the employee would be paid $100,000 and the remaining $100,000 in value of RSUs would be cancelled without payment, continuation or substitution even if the employee stays as an employee after the acquisition.
In a Continuation Plan, an employee would receive the $100,000 deal consideration for the vested shares and a substitution or continuation award in exchange for the $100,000 in unvested value. That might be in the form of cash to vest over time, continuing awards in the acquired company if it survives the merger, or substitute value of the acquiring company's equity, such as RSUs worth $100,000 in value of the acquiring company. Any such replacements would continue to vest over the original remaining vesting schedule.
When Juno, a ride-sharing app which promised 50% of its founders shares to drivers in the form of RSUs, was acquired by Gett for $200 million, they cancelled without payment all RSUs it had awarded and promised to drivers. The merger terms were not made public, but it appears that Juno had a Cancellation Plan allowing the company the right - which they exercised - to cancel unvested RSUs. All RSUs would have been unvested as the drivers reportedly had to work for 30 months to time-vest any of their RSUs and less than a year had passed between the grants and the acquisition.
The drivers instead received a one-time payment, which appears to be dramatically lower than the RSUs would have been valued in the acquisition. It was reported that the maximum portion of the acquisition price they could have received was 1.5%. It's not entirely clear that this is the case, as drivers report that they were never notified of their percentage ownership in the company at the time of the acquisition. But if the paltry payouts - one example was $250 to a driver - were actually at the deal consideration for the deal, it would mean that the original awards were such a low percentage of the company that they would have crossed into absurdity. Therefore, it safe to assume that Juno had a Cancellation Plan and it used it to cut its drivers out of a $200 million acquisition, less than a year after promising its drivers 50% of the company's equity. Ouch.
So if you're negotiating a startup equity offer, ask for the good stuff - a Continuation Plan - or even more favorable single or double trigger acceleration terms. More on those variations here.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Will this Seed Stage Company Become a Unicorn?
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Wondering if your seed stage startup will become a unicorn? Here's a great illustration of your chances from Dustin Moskovitz's presentation, Why to Start a Startup from Y Combinator's Startup School.
Wondering if your seed stage startup will become a unicorn? Here's a great illustration of your chances from Dustin Moskovitz's presentation, Why to Start a Startup from Y Combinator's Startup School.
For more, see the full presentation on YouTube.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.