Startup Stock Options - Post Termination Exercise Period - A $1 Million Problem
Negotiating a startup stock option offer? An option exercise extension can save you from a $1M problem. Photo by Pixabay.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Originally published March 28, 2017. Updated March 17, 2023.
Early Expiration for Startup Stock Options
The startup scene is debating this question: Should employees have a full 10 years from the date of grant to exercise vested options or should their rights to exercise expire early if they leave the company before an IPO or acquisition? This is called a post-termination exercise period or PTEP.
This is Part 1 of a 3-part series. See Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution and Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage. See also The Menu of Stock Option Exercise Strategies for more on option exercise planning and startup offer negotiation.
The standard in the past has been that startup stock options are designed with an early expiration period. They must be exercised by whichever comes first:
10 years after the date of grant or
3 months after the last date of employment. (We’ll call this an “early expiration period.")
If a stock option is not exercised by this deadline, it expires and the individual forfeits all rights to the equity they earned. In some cases, this period is shorter, such as expiration 1 month after or even the day of last employment.
If an employee leaves a startup - by choice or involuntary termination of employment - and has to exercise stock options within an early expiration period, he or she has the following choice:
Pay the exercise price and tax bill with savings or a loan;
Find liquidity for some of the shares on the secondary market (which is complicated, not widely accessible, and sometimes prohibited by company or law) to pay for the cost of the exercise price and tax bill; or
Walk away and lose the vested value.
Startup Stock Options’ $1M Problem
This can be a $1 million problem for employees at successful companies because the tax bill due at exercise is based on the value of the shares at exercise. Either ordinary income or alternative minimum taxable (AMT) income may be recognized at exercise. This income will equal the difference between the option exercise price and the value of the shares at the time of exercise. The value of the shares is usually called fair market value (FMV) or 409A valuation. These values are generally set by an outside firm hired by the company. The company may try to set these valuations as low as possible to minimize this problem for employees, but IRS rules generally require that the FMV increases with investor valuations and business successes.
The more successful the company has been between option grant and option exercise, the higher the tax bill will be. For a wildly successful company, the calculation might look like this:
Here’s an example:
Exercise Price = $50,000
FMV at Exercise = $4 million
Gain (either Ordinary Income or AMT Income) Recognized at Exercise = $3,950,000
Hypothetical tax rate = 25%
Taxes Due for Exercise = $1,027,000
Total Exercise Price + Tax Cost to Exercise = $1,077,000
REMEMBER: FMV at exercise is not cash in hand without a liquidity event. Therefore, if the option holder in this example makes the investment of $50,000 plus the tax payment of $1,027,000, they might never realize the $4 million in stock option value they earned, or even reclaim the $1,077,000 exercise price + tax. The shares may never become liquid and could be a total loss. For someone who goes into debt to exercise and pay taxes, that might mean bankruptcy. So, even if they can come up with $1 million to solve the early expiration problem at exercise, they may have wished they had not if the company value later declines.
Investor-types frame this as a simple investment choice - the option holder needs to decide whether or not to bet on the company by the deadline. But many people simply do not have access to funds to cover these amounts. It’s not a realistic choice. The very success of the company they helped create makes it impossible to exercise the stock options they earned.
Although these numbers may seem impossibly large, I regularly see this problem at the $1 million + magnitude for individual option holders. The common demographic for the problem is very early hires of startups that grew to billion-dollar valuations.
Why Now? Later IPOs, Higher Valuations, More Transfer Restrictions
Early expiration of stock options is a hot issue right now because successful startups are staying private longer and staying private after unprecedented valuations. These successful but still private companies have also been enforcing extreme transfer restrictions. These longer timelines from founding to IPO, higher valuations between founding and IPO, and transfer restrictions are causing the early expiration of stock options to affect more employees.
1. Later IPOs = more likely early expiration applies before liquidity. The typical tenure of a startup employee is 3-4 years. As companies stay private longer, employees are more likely to leave a company after their shares have vested but before an IPO. If they have to exercise within the early expiration period but before an IPO, they must pay taxes before they have liquidity to pay the taxes.
2. Higher valuations = higher grant prices. Exercise prices for stock option grants must be set at the fair market value (“FMV” or “409A Value”) of common stock on the date of grant. If an individual joins a company that has had some success in raising funds and in business, the FMV at grant will be higher. Therefore, departing employees are more likely to have hefty exercise prices to pay within an early expiration period. With delayed IPOs they are unlikely to have access to liquidity opportunities to cover exercise prices.
3. Higher valuations = higher tax due at exercise. Total tax bills at exercise are more likely to be high as the company valuations are high because taxable income (either ordinary income or alternative minimum taxable income) is generally equal to FMV at Exercise - Exercise Price. With delayed IPOs, employees are unlikely to have access to liquidity opportunities to cover tax bills.
4. Extreme transfer restrictions = no liquidity prior to IPO or acquisition. In the past, private company stock could be transferred to any accredited investor so long as the seller first offered to sell the shares to the company. (This is known as a right of first refusal or ROFR. The market for pre-IPO stock is known as the secondary market.) Some companies are prohibiting such secondary market transfers and similar structures such as forward sales or loans that had historically allowed employees of hot companies to get liquidity for the shares to pay for exercise costs and tax bills at exercise. Some companies add these transfer restrictions after issuing the shares and even push the limits of the law by claiming that they can enforce new restrictions retroactively.
I hope this post has illuminated the problem of an early expiration period for startup stock options. For more on a solution to the problem, see Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution. See also Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage.
Thank You!
Thank you to JD McCullough for providing research assistance for this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.
Thank you to attorney Augie Rakow, a former partner at Orrick advising startups and investors, for sharing his creative solution to this problem in Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Part 1: Why You Need a Startup Stock Option Exercise Strategy
Wondering when to exercise stock options at a startup? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake. Photo by Andrea Piacquadio.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
When to Exercise Stock Options?
Startup stock options can be extremely lucrative or extremely disappointing. The biggest disappointments are not from companies that never succeed, but from employees of successful companies that are not able to take advanteBefore you accept a startup stock option offer, you will want to have a strategy in place for exercising those options. This up-front attention will save you from the unhappy but common surprises associated with startup stock options, such as these recent examples:
Forfeiture at Termination. Sales executive drove sales and company value for four years and was terminated a few months before a $1B company exit. He could not afford the $1M exercise cost (to cover the exercise price and tax cost of exercise) within the 30-day post-termination exercise deadline, so he was forced to forfeit most of his vested options. He made approximately $500K at the exit; his former colleagues with similar equity grants made $10M.
Golden Handcuffs. Early hire at a future unicorn did not early exercise his startup stock options or exercise as they vested. He wanted to leave the company after four years when he was fully vested, but he could not afford the $2M cost to cover the exercise price and tax cost of exercise. Therefore, he had to stay at the company for 3 more years while he waited for an acquisition, frustrated that he was not able to move onto his next opportunity.
Tax Expense. Early hire at a future public company waited to exercise his options with a total exercise price of $5,000 until after the shares became publicly traded. He had to sell the shares on the same day as the exercise to cover the tax expense of exercise. Since he had not held the shares for a year before sale, his gains were taxed at ordinary income tax rates of over 40%. If he had early exercised the options, he would have qualified for QSBS tax treatment on his gains, resulting in 0% federal tax rates and saving him >$1M in taxes.
In the Part 2, you will see the menu for startup stock option exercise strategies to save yourself from these unhappy surprises. In Part 3, you will see a Q&A on FAQs re stock option exercise strategies.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Tax Changes for Startup Executives and Employees - Tax Cuts and Jobs Act of 2017 - Q1 2018 Newsletter - Stock Option Counsel, P.C.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Here's our Q1 2018 Newsletter. Sign up for our mailing list to receive these quarterly updates!
Hello Startup Community!
The final Tax Cuts and Jobs Act of 2017 is already affecting startup equity holders. Check out my recent blog posts on Tax-Deferred Option Exercises Under the New Section 83(i) and Incentive Stock Options & Changes to the Alternative Minimum Tax. Here's the short version.
Tax Deferral for Option Exercise - New Section 83(i) Election. The new Section 83(i) was designed to defer taxation from a stock option exercise until the shares become liquid. Unfortunately, the details of the new Section 83(i) make it unlikely to work for most startup option holders. But where it does apply it will defer taxation for up to five years from the date of option exercise with the use of the new Section 83(i) Election. These are the key details of the new Section 83(i).
Tax Relief for ISO Exercise - New AMT Limits. Dramatic increases to the exemption amounts and phase out thresholds of the Alternative Minimum Tax (AMT) will allow many more startup employees to exercise Incentive Stock Options (ISOs) tax-free. This allows for more planning opportunities to take advantage of the potential ISO tax benefits of capital gains tax rates on all gains. These are the key details of the AMT changes as they relate to ISO exercise.
Startup Offer Negotiation Tips. What does this mean for our clients negotiating new stock option offers? First, the new Section 83(i) will not provide wide relief from pre-liquidity tax burdens for stock option exercise. So it still makes sense to negotiate for a tax-deferred structure such as early exercise or an extended post-termination exercise period. Second, since the revised AMT limits make the ISO benefits even more appealing than ever, ISOs are far more appealing than NSOs for most people (unless the options will be early exercised.)
Stock Option Counsel, P.C. - Legal Services for Individuals. Thank you for your enthusiasm for my practice and for the Stock Option Counsel Blog! I will continue to send quarterly updates on important topics in the market for startup equity for individual founders, executives and employees. Please keep in touch.
Best,
Mary
Mary Russell | Attorney and Founder
Stock Option Counsel, P.C. | Legal Services for Individuals
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Incentive Stock Options and the Alternative Minimum Tax - Changes under the Tax Cuts and Jobs Act of 2017
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 final Tax Cuts and Jobs Act of 2017 will reduce Alternative Minimum Tax ("AMT") bills for many who exercise Incentive Stock Options ("ISOs") in two ways - one direct and one indirect.
First, the bill increased exemption amounts and phase-out thresholds for the AMT as follows:
The increased AMT exemption decreases the likelihood of triggering AMT at exercise of ISOs. For those ISO exercises that do trigger AMT, the increased AMT phase-out threshold may reduce the amount of AMT due. The result of these changes is a maximum savings of $18,000 for an individual exercising ISOs.
Second, the bill reduced or repealed several triggers of the prior AMT, such as state and local tax deductions. This reduces the number of taxpayers who will need to use their AMT exemption amount for non-ISO AMT items. According to Joe Rosenberg of the Tax Policy Center, as quoted in the Wall Street Journal, only about 200,000 returns will be subject to AMT in 2018 down from approximately five million in 2017. So starting in 2018 most taxpayers will not have “used up” the AMT exemption amount on non-ISO related items and therefore will be able to use the entire AMT exemption amount to offset gains at exercise of options. In addition, these new thresholds may trigger the release of AMT credit carryovers.
“These changes are somewhat anticlimactic after legislators almost repealed the entire Alternative Minimum Tax, which would have made all ISO exercises tax-free. But they may result in savings of up to approximately $18,000 in AMT for a ISO exercise.”
What does this mean for existing ISO grants?
These changes are somewhat anticlimactic after legislators almost repealed the entire Alternative Minimum Tax, which would have made all ISO exercises tax-free. But they may result in savings of up to approximately $18,000 in AMT for a ISO exercise. So it makes sense to work with your tax advisor and/or financial planner to decide if/when to exercise to take advantage of the benefits of the new rules. Here are some choices on ISO exercise:
1. Early exercise some ISOs prior to vesting (if allowed under grant documents);
This is a tax planning maneuver to start your capital gains holding period and avoid paying taxes at exercise. (If you have ISOs you are considering for early exercise, you might prefer to have them converted into NSOs before early exercising. See more on this issue here.)
2. Exercise some ISOs after vesting and prior to liquidity; or
Precisely planning your ISO exercises can allow you to take advantage of the ISO benefits, which will be more favorable under the revised AMT limits. Work with your accountant or financial advisor to determine precisely how many ISOs can be exercised per year to fall within the AMT exemption amount for your phase-out threshold status.
3. Wait to exercise all ISOs until the shares will be sold to pay the taxes due at liquidity and the exercise price.
This is likely to have the highest tax rates but the lowest investment risk. However, if the ISOs expire early at employment termination, leaving your job may make this impossible. More on this issue here.
What does this mean for negotiating a new stock option offer?
ISOs are more favorable than NSOs (unless you are early exercising while the exercise price is equal to the FMV). The revised AMT limits make their benefits even more appealing. So, if you are negotiating a stock option offer, make sure the grant will qualify as ISOs up to the limits under the law.
I would be happy to hear from you if you are navigating an existing option grant or negotiating a new offer. For more information, please see this FAQ or contact me at (650) 326-3412 or by email.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.