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.
