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.