startups, Stock Options, Restricted stock units, How to negotiate equity in a startup, How much equity should I ask for? Mary Russell startups, Stock Options, Restricted stock units, How to negotiate equity in a startup, How much equity should I ask for? Mary Russell

Startup Compensation Data Sources

Here’s some links to helpful market data for startup equity offers. Individuals negotiating a startup offer often struggle to find good resources for startup compensation data since the key data sources are only available on the company side.

Negotiating startup salary and stock options or RSUs? These are links to market data that readers have found helpful.

Negotiating startup salary and stock options or RSUs? These are links to market data that readers have found helpful. Photo by ThisIsEngineering.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Published February 2023. Updated regularly.

Market Data Sources

Individuals often struggle to find good resources for startup compensation data since subscriptions to the primary startup compensation data sources are only available on the company side. Companies are using Pave (including the classic Advanced-HR Venture Capital Executive Compensation Survey, now owned by Pave), Radford, Mercer, and Carta. The information imbalance is challenging to say the least.

October 2024 update: Pave is currently the most highly-respected data source for startups, so that is the gold standard right now for startups making offers. However, Pave has the least access available to individuals. If you’re at Pave and want to help rectify this, let me know :). Carta has the most access for individuals (see below re Friends of Carta), but it’s numbers skew very low in my experience.

Here’s some links that readers have found helpful:

Good luck! Please send along anything you’d like me to include on this list.

How to Use Market Data

And here’s some good links on how to use market data. They are written for companies, but helpful to any individual’s thoughtful approach to this topic.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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VIDEO Startup Stock Options: Negotiate the Right Startup Stock Option Offer

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.

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Risk/Reward of Startup Employee 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.

Startup employee equity should reward the risk you take in joining the company. Here's some ways to understand equity value so you can decide if your equity meets this standard.

For more information on joining an early stage startup before there is a VC valuation, see Joining An Early Stage Startup? Negotiate Your Salary and Equity with Stock Option Counsel Tips.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Startup Negotiations: How Preferred Stock Makes Employee Stock Less Valuable

Originally published February 13, 2014. Updated August 30, 2023.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Common Stock v. Preferred Stock

Startup employees and executives get Common Stock (as options, RSUs or restricted stock). When venture capitalists invest in startups, they receive Preferred Stock.

Preferred Stock comes with the right to preferential treatment in merger payouts, voting rights, and dividends. If the company / founders have caved and given venture capitalists a lot of preferred rights - like a 3X Liquidation Preference or Participating Preferred Stock , those rights will dramatically reduce the payouts to Common Stock in an acquisition. An individual who holds 1% in common stock would be curious, therefore, about the preferred stock’s rights to know if their 1% would really be 1% in an acquisition.

Is Preferred Stock Negotiable for Employees and Executives?

No. Preferred Stock is not negotiable for employees and executives (other than perhaps founders preferred stock which relates not to acquisition payout amounts but to liquidity rights and voting rights). The key is to understand if the investors’ Preferred Stock has unusual, off-market liquidation preferences. If so, that would weigh in favor of negotiating for more shares, more cash compensation or - less often but occasionally - management retention plan terms to make up for uninspiring Common Stock rights.

Liquidation Preference & How It Affects Common Stock Payouts

One Preferred Stock right is a "Liquidation Preference." Without a Liquidation Preference, each stockholder – preferred or common – would receive a percentage of the acquisition price equal to the stockholder's percentage ownership in the company. If the company were acquired for $15 million, and an employee owned 1% of the company, the employee would be paid out $150,000.

With a Liquidation Preference, preferred stockholders are guaranteed to be paid a set dollar amount of the acquisition price, even if that guaranteed payout is greater than their percentage ownership in the company.

Here’s an example of the difference. An investor buys 5 million shares of Preferred Stock for $1 per share for a total of $5 million. After the financing, there are 20 million shares of common stock and 5 million shares of Preferred Stock outstanding. The company is then acquired for $15 million.                                                                                                                           

Without a Liquidation Preference, each stockholder (common or preferred) would receive $0.60 per share. That’s $15 million / 25 million shares. A hypothetical employee who held 1% of the company or 250000 shares) would receive $150,000 (that’s 1% of $15 million).

If the preferred stockholders had a 1X Liquidation Preference and Non-Participating Preferred Stock, they would receive 1X their investment ($5 million) before any Common Stock is paid in an acquisition. They would receive the first $5 million of the acquisition price, and the remaining $10 million would be divided among the 20 million shares of common stock outstanding ($10 million / 20 million shares of common stock). Each common stockholder would be paid $0.50 per share, and hypothetical employee who held 1% of the company would receive $125,000.

In an up-round acquisition, though, this 1X non-participating preference would not affect common stock payouts. In an acquisition at $100 million valuation, the investors would choose the higher of:

  • Their $5M liquidation preference and

  • Their percentage of the company valuation. If they had 20% of the company’s shares, they would of course here choose $20M in payouts. And all common stockholders would also receive their percentage payout.

Ugly, Non-Standard Rights That Diminish Employee Stock Value

The standard Liquidation Preference is 1X. This makes sense, as the investors expect to receive their investment dollars back before employees and founders are rewarded for creating value. But some company founders give preferred stockholders multiple Liquidation Preferences or Participation Rights that cut more dramatically into employee stock payouts in an acquisition.

If preferred stockholders had a 3X Liquidation Preference, they would be paid 3X their original investment before common stock was paid out. In this example, preferred would be paid 3X their $5 million investment for a total of $15 million, and the common stockholders would receive $0. ($15 million acquisition price – $15 million Liquidation Preference = $0 paid to common stockholders)

Preferred stock may also have "Participation Rights," which would change our first example above to give preferred stockholders an even larger portion of the acquisition price.

Without Participation Rights, Preferred Stockholders must choose to either receive their Liquidation Preference or participate in the division of the full acquisition price among the all stockholders. In the first example above, the preferred stockholders held 20% of the company and had a $5 million Liquidation Preference. When the company was acquired for $15 million, the preferred stockholders had the choice to receive their $5 million liquidation preference or to participate in an equal distribution of the proceeds to all stockholders. The equal distribution would have given them $3 million (20% of $15 million acquisition price), so they chose to take their $5 million liquidation preference, and the remaining $10 million was divided among 20 million shares of common stock.

If the Preferred Stock also had Participation Rights, (which is called Participating Preferred Stock), they would receive their Liquidation Preference and participate in the distribution of the remaining proceeds.

In our example with a 1X Liquidation Preference but adding a Participation Right, the Participating Preferred Stock would receive their $5 million Liquidation Preference AND a portion of the remaining $10 million of the acquisition price equal to their % ownership in the company.

$5 million Liquidation Preference + ((5 million shares / 25 million shares outstanding) * $10 million) = $7 million

Common stockholders would receive (20 million shares common stock / 25 million shares outstanding) * $10 million = $8 million.

Our hypothetical employee who held 1% of the company would receive $100,000 (.01 * $10 million) or 0.67% of the acquisition price.

Employee Focus – Quick and Dirty Analysis

These calculations are complicated, so most candidates who are evaluating a startup job offer keep it simple in considering the effects of preferred stock. The quick and dirty way to know if preferred stock is an issue in evaluating an equity offer is to find out:

Do preferred stock investors have any liquidation preferences beyond the standard 1X non-participating preference?

If not, it’s not an issue in any up-round acquisition (and so most startup hires would not be concerned about the preferences at hire).

Founder Focus – Negotiating Your Acquisition Payout

If you are a founder and are negotiating with an acquiror, consider renegotiating your investors’ Liquidation Preference payout. Everything is negotiable in an acquisition, including the division of the acquisition price among founders, investors and employees. Do not get pushed around by your investors here, as their rights in the documents do not have to determine their payout.

If your investors are pushing to receive the full Liquidation Preference and leaving you and/or your employees with a small cut of the payout, address this with your investment bankers. They may be able to help you play your acquiror against the investors so that you are not cut out of the wealth of the deal, as most acquirors want the founders and employees to receive enough of the acquisition price to inspire them to stay with the company after acquisition.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Thanks to investment banker Michael Barker for his comments on founder merger negotiations. Michael is a Managing Director at Shea & Company, LLC,  a technology-focused investment bank and leading strategic advisor to the software industry.

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Double Trigger Acceleration and Other Change of Control Terms for Startup Stock, Options and RSUs

Startup Equity | Double Trigger Acceleration | 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:

  1. Full acceleration so that a qualifying termination at any time after acquisition accelerates 100% of unvested shares;

  2. Application to a qualifying termination in anticipation of, or for a certain protective period of time prior to, change of control;

  3. Application to terminated by the company for Cause (narrowly defined, not to include arguable performance terms);

  4. 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);

  5. A broad definition of change of control including a sale of substantially all the company’s assets;

  6. 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.

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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.

Startup valuation basics

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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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.

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Startup Stock Options | Post Termination Exercise Period | The Full 10-Year Term Solution

Working for startup stock options? An option exercise extension can save you from a $1M problem.

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.

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Startup Stock Options - Post Termination Exercise Period - A $1 Million Problem

Working for startup stock options? An option exercise extension can save you from a $1M 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:

  1. 10 years after the date of grant or

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

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

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

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

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

  3. Walk away and lose the vested value.

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.

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Part 3: FAQs on the Menu of Startup Stock Option Exercise Strategies

The menu of startup stock option exercise strategies. How to plan ahead to protect your equity stake.

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.

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The Myth of Startup Employee Equity

Startup equity compensation has incredible power to recruit and retain tech talent. However, the reality of percentage ownership, stock option exercise taxes, and repurchase rights can prevent employees from making equity work for employees.

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.

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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.

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.

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Part 2: The Menu of Startup Stock Option Exercise Strategies

Wondering when to exercise stock options? 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.

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.

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Part 1: Why You Need a Startup Stock Option Exercise Strategy

Working for a startup? Here's the menu of startup stock option exercise strategies. How to plan ahead to protect your equity stake.

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.

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Part 2 - Examples of a Clawback Clause for Startup Stock

Working for a startup? Learn how a clawback clause, forfeiture term or repurchase right limits the value of startup equity. Plan ahead to protect your equity stake.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

What is a Clawback Clause?

Startup hires expect that they will be able to keep their vested shares if they leave the company before an exit event. That’s not always the case. Learn more in Part 1 of this series - Clawbacks for Startup Stock - Can I Keep What I Think I Own - about how a clawback clause limits the value of startup equity.

In this post, we will share some examples of a clawback clauses or clawback provision that would allow startups to take back vested shares or options.

What is an Example of a Clawback Clause?

Equity Incentive Plan I

The company reserves the right to include clawbacks for vested shares upon an individual's termination of employment:

Repurchase Right. The Company (and other designated Persons) may repurchase any or all of the shares of Stock granted to a Participant pursuant to an Award or acquired by the Participant pursuant to the exercise of a Stock Option upon such Participant’s termination of employment with, or Service to, the Company for any reason to the extent such a right is provided in an Award Agreement or other applicable agreement between the Company and the Participant.

Such terms could be included in any agreement with the individual, such as a Stock Option Grant Notice, a Stock Option Agreement, a Stock Option Exercise Agreement, a Termination and Release or Severance Agreement, a Restricted Stock Agreement, an RSU Agreement, an Employment or IP Agreement, or a Stockholders' Agreement.

Equity Incentive Plan II

The company reserves the right to implement a policy in the future to clawback vested or unvested shares, and you’re agreeing that such a change will apply retroactively to your shares:

Clawback Policy.  The Awards granted under this Plan are subject to the terms of the Corporation’s recoupment, clawback or similar policy as it may be in effect from time to time, as well as any similar provisions of applicable law, any of which could in certain circumstances require repayment or forfeiture of Awards or any shares of Common Stock or other cash or property received with respect to the Awards (including any value received from a disposition of the shares acquired upon payment of the Awards).

Stock Option Agreement

The company reserves the right to change its bylaws in the future to clawback vested or unvested shares, and you’re agreeing that such a change will apply retroactively to your shares:

Right of Repurchase. To the extent provided in the Company’s bylaws in effect at such time the Company elects to exercise its right, the Company will have the right to repurchase all or any part of the shares of Common Stock you acquire pursuant to the exercise of your option.

These two terms allowing retroactive changes push the limits of Delaware law on company repurchase rights. However, I advise my clients to negotiate these out of their documents before joining a company to avoid litigation at a later date.

Restricted Stock Unit Grant Notice

In order to vest RSUs, the time-based vesting requirement (the "Time Condition") must be met, and the Company must have an IPO or a Change of Control (the "Performance Vesting") prior to the 7 year expiration period of the RSU.  This is a normal structure for a startup RSU grant due to tax planning. However, in this example, if the IPO or Change of Control does not occur by the individual's last date of employment, the RSUs are cancelled and never vest:

Vesting Conditions. Any Restricted Stock Units that have satisfied the Time Condition as of such date shall remain subject to the Performance Vesting set forth in Section 2(b) above, but shall expire and be of no further force or effect on the first to occur of (a) the date on which the Grantee’s Service Relationship with the Company terminates, or (b) the Expiration Date.

Employment and Confidentiality Agreement

The company reserves the right to terminate vested options in the event of a breach of the agreement:

Breach of Confidentiality Agreement. If the Optionee breaches the provisions of the Confidentiality Agreement, then any outstanding Options held by such Optionee at the actual time of such termination shall thereupon expire, terminate and be cancelled in respect of all vested and unvested Option Shares.

Breach of Non-Competition and Non-Solicitation Covenant. If the Optionee breaches the Non-Competition and Non-Solicitation Agreement, then any outstanding Options held by such Optionee at the actual time of such termination shall thereupon expire, terminate and be cancelled in respect of all vested or unvested Option Shares.

While these two examples from employment and confidentiality agreements apply to restrictions on exercising options, similar terms may also apply to repurchase or forfeiture of vested shares for violations of such agreements even after termination of employment. More on this here from the National Association of Stock Plan Professionals in June 2023.

Other Clawback Clauses

These are only a few examples of how clawbacks might appear in an equity offer. There are more ways they can appear in the fine print. And, practically, an option exercise deadline acts as a clawback as well. Having only 3 months to exercise options is a standard market term, but it often acts to prevent employees and executives from exercising their vested shares. More on this in:

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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.

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