We wrote here why we believe giving employees 10 years (i.e. the full term of their options) to exercise their stock options is the future of startup employee compensation.
If you have an existing option plan in place, amending it requires thought and analysis of the tradeoffs. We encourage every company to think about this deeply and make an informed decision. What we want to make clear is that it is possible to amend outstanding options held by existing employees and add a longer post-termination exercise window to them.
There has been a lot of discussion on this topic, with arguments made both for and against implementing the extension. When talking with founders who agreed with making the change in principle, but were deterred by speaking with lawyers, we found there to be a lot of misinformation about the key issues in circulation.
Here is a summary of the issues, both business and legal, we most commonly hear brought up by founders thinking through this. Our goal here is to provide the information needed to raise this topic for internal discussion with your team and make a decision.
1) This matters only to the “wrong” kind of employee
Issue: The exercise window matters most to the mercenaries who want to move onto the hot new company each year. The company will lose an important retention mechanism that comes with options.
Thoughts: Having people stay at your company because they feel locked in isn’t good for employee morale. Companies want motivated people working for them, and should find positive ways to incentivize employees to remain in employment. Companies can also implement the option extension in a way to encourage retention by requiring employees remain in employment for e.g. 2 years to be eligible for the option extension. This is how Coinbase and Pinterest implemented it.
2) This is worse for employees from a tax perspective
Issue: There are two types of stock options, incentive stock options (ISOs) and nonstatutory stock options (NSOs). Only NSOs can have this extended exercise window but they also have less favorable tax treatment than ISOs.
Thoughts: It’s true that ISOs have better tax treatment than NSOs but the difference is not as great as commonly thought because of AMT (Alternative Minimum Tax). To understand this, let’s compare how the tax treatments differ at the two most important events, exercising your options and selling your stock.
1. Employee exercises stock option
ISO: Employee now owes AMT (Alternative Minimum Tax) on the difference between the amount they paid to exercise their options (the exercise price) and the fair market value of that stock today. Calculating exactly AMT can be tricky, most likely you’ll pay 28% on the difference.
NSO: Employee owes Ordinary Income Tax (38%) on the difference between the exercise price and fair market value of the stock.
2. Employee sells stock
ISO: Employees owes capital gains tax on difference between the sale price and fair market value of the stock at exercise. If this sale happens within a year, you’ll owe short term capital gains (38%). If it’s been over a year and two years since the options were granted, you’ll owe long term capital gains (20%).
NSO: The capital gains treatment is the same as above.
You can see the tax difference between ISOs and NSOs is most important at the time of exercise. What’s important is companies don’t have to decide whether employees get the flexibility of an NSO or the preferential tax treatment of an ISO. Employees can make this decision themselves. If an employee exercises their options, post leaving the company, within 90 days they’ll still get the ISO tax treatment. Otherwise they’ll get NSO tax treatment. They can decide whether to tradeoff better tax treatment against the flexibility of having more time to decide if they’d like to exercise.
3) Cap table management
Issue: Increasing the post-termination exercise window means having shareholders who haven’t been actively involved with the company for years. This equity could have been “re-invested” to incentivize new or current employees. This also makes cap table management difficult, putting a burden on the company to keep updated contact information for them all.
Thoughts: Stock options are a reward for work that has already been done. Once vested, employees deserve to own their options outright and have the opportunity to exercise the rest of their vested options. The additional administrative overhead is small in comparison to protecting this right.
4) Dual class of employees
Issue: Extending the exercise window is not possible for existing employees and will only be applicable to new hires. This creates two classes of employees, penalizing the loyal long-time employees whose options did not originally have the option extension.
Thoughts: This is simply not true. It is possible to amend outstanding options held by existing employees to add an option extension. This amendment may convert an incentive stock option (ISO) into a nonstatutory stock option (NSO), and the company may have to comply with the tender offer rules to offer employees this option extension. However, this is completely feasible, and many companies have complied with the tender offer rules to implement this.
5) Better handled on a case by case basis
Issue: This issue is better handled on a case by case basis with each individual employee. Companies should have a personal conversation and find the best solution for each person, rather than offering this to everyone by default.
Thoughts: Option extensions require board and optionee consent. Handling option extensions on a case by case basis is administratively burdensome, because the company has to remember to seek board approval of an option extension each time someone leaves. In addition, a case by case analysis may make the company vulnerable to a claim of discrimination if employees and their options are not treated in the same manner. Finally, if there are multiple case by case option extensions, there comes a point when the tender offer rules will get triggered anyway, because of the number of option extensions that have been offered. This isn’t something a company wants sprung upon them without time to prepare for it.
Legal and Accounting Issues
1) Tender Offer
Giving current employees the decision whether to keep their ISOs without the option extension or have NSOs with the extension is an investment decision, which may require the company to engage in a tender offer when offering the option extension. This tender offer process is relatively easy to implement, but the company has to give its employees at least 20 business days to think it over and decide.
2) Accounting Charge
An option extension will likely result in a higher accounting charge with respect to the options, although many companies have not found this additional charge to be material. The company needs to check with its outside auditors on the accounting implications of an option extension, which will vary depending on the number of options affected by the option extension and the length of the option extension.
With an option extension, a company can anticipate that most options will be NSOs when exercised. If NSOs are exercised when there is a gain on the exercise date, the company will incur an additional tax cost, because the company has to pay the employer portion of the employment tax on such gain. At the same time, the company gets a deduction equal to the gain recognized on the exercise of an NSO, so the company has to balance the cost of the employment tax against the benefit of a tax deduction. There is no comparable tax cost with the exercise of an ISO.
If the company is acquired, occasionally, a buyer may require that the company track down all former employee optionees to obtain their consent to the option treatment, as a closing condition. However, the form of the Triplebyte stock plan is drafted to give maximum flexibility in the treatment of options in an acquisition, so optionee consent to the option treatment shouldn’t be required in most acquisitions.
Due to the option extension, there may be more options outstanding at an IPO, which may result in a larger overhang (i.e. larger number of outstanding equity). However, it’s possible that the company will have a similar overhang without the option extension, if most optionees exercise options and become shareholders.
If you have any questions about these, please get in touch. More companies are starting to follow the trend set by Pinterest, Quora, Coinbase, Amplitude and others and we’d like to see this become the standard.
A collection of thoughts discussing this issue we’d recommend reading:
Thanks to Nancy Chen at Orrick for providing the legal details in this post.