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.
Company-Side Education Programs on Startup Equity - Feedback from Newsletter Subscribers
Here’s a quick primer on how to negotiate stock options or RSUs in a startup. It's up to individuals to educate and empower themselves when company-side education programs are lacking. Photo by Alena Darmel.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
I asked my newsletter subscribers to share their experiences with startup company employee equity education programs. Thank you for all your responses! I love being in touch and hearing your feedback.
See below under My Takeaways for a quick primer on how employees can empower themselves by taking the initiative to learn about startup equity and ask their companies for the information they need to make informed decisions.
Individuals reported these company programs they found very helpful:
Company all-hands meetings followed by both (1) smaller working groups led by the CEO/CFO using real world tangible scenarios to explain and provide context and (2) one-on-ones with senior management.
Training sessions with the company’s CFO.
Carta, including blog content, presentations, Equity 101 posts, and online calculators. “Very good interface with clear information.”
Individuals reported these company programs they found somewhat helpful:
Company-wide information meeting on stock options, but not provided until years after the employee joined the company.
Carta as stock administrator. This allows employees to “have more access and run the calculator more frequently. But it doesn’t speak to the non-price issues like post-termination exercise periods, forced share repurchase,” etc. Also, “Carta maximizes for startup friendliness, and here employee friendliness runs counter to that goal.”
ShareWorks as stock administrator. The “account includes the value of your options based on the latest valuation. From a user experience, [though,] it is clunky like most financial software products.”
Individuals reported these company programs they found not helpful or harmful:
Company education program on stock option exercise by a stock broker who was “in it for himself and not the employees. … The education they were offering was to inform the newly wealthy employees how to “invest” their new found cash. It is not a good strategy to use someone like that for that purpose … I lost about $1M of the money I earned from the startup. It was disastrous. If companies host an individual, make sure they are fiduciaries and not brokers.”
Company-wide information meeting with general information and many disclaimers, which was “not that helpful for making actionable decisions. … I think the presentations backfired because most either didn’t understand options any better than they did prior to the meeting and those that did realized their options weren’t that valuable (which was the opposite motivation of the CEO).”
In a geographic area where “most employees aren’t stock option aware …, although we granted stock options to all employees, most ignored them because they were difficult to understand. And HR was unable to answer any questions about options because they didn’t understand them. … In the case of recruiting and offers -- the lore was more important than the facts.”
Recruiters who “fail to disclose the material issues, and sometimes state that the equity situation is more favorable than it actually is.”
Individuals reported these wish-list items they had not yet seen:
“If this were my project, I would use a framework of virtual recorded introductory education sessions that give the basics of the compensation program, and a one-on-one follow up to cover any lingering questions. I would build out a self-help knowledge base that covers common lingering questions and/or use that info to improve the education sessions.”
“I like the idea of a 3rd party to provide the trainings, mixed with key staff or founder interaction to build trust.”
Examples, simplicity, transparency and opportunities for lots of Q&A in small groups. A library of content that addresses common questions, concerns and misconceptions would also be very valuable.
“It would be great if our law firm had established programs to walk us through the process.”
“What employees really want to know is -- what is the value of my options under various realistic scenarios. One approach might be several if-then scenarios and then employees can decide which one of those hypothetical scenarios most applies to them.”
“Options seem to be presented as a commodity component to most offerings with a presumed windfall. … It’s important to manage expectations of what the value is and how to think about that; how to act, when, why.”
An educational program would need to provide an “overview, some tools for employees to calculate future sums/ exit projections (dream a bit), and cover common tax issues, maybe an overview of company/venture process (what the near future could mean for equity holders), and gotchas like: what happens to my vested equity if I have to leave the company.”
Services providers reported these as service offerings they had available to companies:
Note: If you are a service provider in this area with an offering I have not included, please send me an email with a description of your services so I can add it to the list.
Dan Walter, FutureSense. Dan advises companies on executive pay, equity compensation, incentive compensation, and pay for performance. He says that employee education “is a normal piece of our deliverables for nearly every company we work with.” I’ve seen him speak on these topics and he has, as promised, “a unique ability to help anyone understand even the most complex and technical details in ways that are approachable and memorable.”
Bruce Brumberg, myStockOptions.com. Bruce’s site, myStockOptions.com, is the “premier source of web-based educational content and tools on stock compensation for plan participants, financial advisors, companies, and stock plan providers.” They license their educational resources to companies for their programs.
Tom Bondi, CPA, Armanino, LLP. Tom offers company-side employee stock/equity training programs to companies with from 25-500 employees, where the companies wish to give back to their employees with knowledge they are not able to offer.
Financial Advisors who are available to companies in the run-up to an IPO or acquisition to educate the company’s employees.
Carta’s Tax Advisory. Updated February 2023: This add-on to Carta’s cap table service allows startups to help their employees make tax decisions around their equity. Employees of subscribing companies have access to one-on-ones with tax advisors such as: Ask a Quick Question (15 minutes), Understand Equity Tax Basics (30 minutes), Create Tax Scenarios (45 minutes) and Discuss Tender Offer Participation (30 minutes).
My takeaways:
Some company-side education programs are helpful to employees in navigating their equity. However, it is up to individual employees to empower themselves by taking the initiative to learn about startup equity and ask their companies for the information they need to make informed decisions.
Here’s a quick primer on how individuals can do this (based on this blog post):
Number of Shares. The offer letter may include the number of shares, but this number is certainly not all you need to evaluate and negotiate the offer. I encourage candidates to ask questions about the equity package and number of shares until they have the information they need to make an informed decision. More on evaluating the number of shares in an offer letter here.
Equity Grant Form Documents. The equity incentive plan and form stock option agreement contain important details about the equity grant, so it makes sense to request and review them before signing the offer letter. These agreements may give the company clawback rights for vested shares or other terms that may dramatically limit the value of the equity offer. If these red flags appear in the form documents, it makes sense to negotiate to remove them from your individual grant or add additional compensation to make up for that loss in value.
Tax Structure. The right tax structure for an option or RSU offer will balance your interests in total value, low tax rates, tax deferral and investment deferral. This balance is different for each individual and at each company stage. You will want to have a tax strategy in mind before accepting the offer letter, so you can negotiate any necessary terms to enable that strategy as part of the offer letter itself.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.