Equity awards and stock options, in particular, are linchpins among the recruiting tools relied on by venture-backed companies. Accordingly, companies interested in prioritizing transparency should make efforts to ensure that their employees understand the factors affecting the prospective value of their awards. Further, employers aiming to promote cultures of shared ownership should implement compensation structures and policies that in fact permit it. Unfortunately, the value of stock options is unpredictable, and often inadequately rewards employee contributions, partly as a result of the standard three-month post-termination exercise window. In response to this gap between expectations and reality, much has been written on the subject of extending post-termination exercise windows.
Based on my experience advising startups, employers considering extended post-termination exercise windows can benefit from focusing on a few key considerations.
Post-Termination Exercise Windows
A typical stock option agreement for an employee working at a startup allows the employee to exercise any vested options for a period of three months following their departure from the company. This assumes that the employee is departing under routine circumstances and has not been terminated for “cause.” Any vested options that the employee fails to exercise during this three-month window will expire and no longer be exercisable. Any shares subject to such an expired option will then be cycled back into the equity pool, available for the company to issue to new hires. Seems fair enough.
What many employees may not appreciate though is that exercising prior to a liquidity event is costly and may be prohibitively costly for an employee with three months to act. The exercise price of employee options can amount to tens or hundreds of thousands of dollars. Employees who leave their jobs before a company liquidity event, such as an IPO or an acquisition, either need to pay this exercise price out of pocket or otherwise lose the value of their equity. In order to meet this cash demand, some employees resort to taking out a loan while others rely on private secondary sales, exercising their options using a portion of the proceeds from the simultaneous sale of the underlying shares. While either approach can prove effective, both present their own complexities and potential pitfalls for unknowing employees. In the case of the former, employee-debtors are exposing themselves to the risk that the value of their shares drops, leaving them with debt and insufficient asset value to support it. In the case of the latter, employee-sellers trying to navigate an opaque market can, in the extreme cases, wipe out all of their sale proceeds covering taxes.
In light of the challenges faced by employees attempting to reap the value of their stock options before a liquidity event, some companies have begun extending the three-month post-termination exercise window. Doing so increases the likelihood that employees will still be holding their options upon a company liquidity event that allows them to cash in. A number of factors should be considered when deciding what kind of post-termination exercise window is right for a company. To get started exploring the suitability of an “extended” window, founders should weigh the arguments that I’ve encountered for and against it, laid out below.
Arguments for Extended Exercise Windows
Argument 1: The traditional three-month exercise window disadvantages less wealthy employees
As discussed above, exercising options can cost a significant amount of money. If an employee departs before a liquidity event, whether that employee is able to retain the potential benefit of their equity will very likely depend on whether that employee has sufficient funds to cover this exercise cost. This of course disadvantages cash-strapped employees (who, it bears mentioning, may be cash-strapped because they accepted a lower salary in exchange for the prospective value of their stock options). Even if an employee does have the cash to cover the cost of exercise, recall that an option exercise is an investment, meaning there is no guarantee that an exercised option ever produces a return for the employee. For many employees, the prospect of exercising options outside of a liquidity event is simply a non-starter. Such employees should be permitted, the argument follows, to exercise their options within a period of time that feasibly allows them to do so.
Options vested are options earned
The argument is often made that options are a retention tool and thus employees who want to retain the value of their options should be encouraged to continue their employment, which is undermined by extending exercise windows. A counterargument is that vested options reflect the work employees have performed and the value they have generated for a company. Vesting adequately serves to retain employees while ensuring they don’t prematurely depart the company with undue compensation. With that in mind, once an employee’s options have vested, the right to exercise those options has been earned and should not be lost due to the employee’s inability to afford the cost of exercise. A compromise between these two schools of thought, which encourages retention while acknowledging the inequity of traditional exercise windows, is to extend exercise windows on a tiered basis, with extensions commensurate to an employee’s tenure with the company.
Argument 2: Extended windows can be a recruiting tool
A second argument in favor of extended exercise windows presupposes that the prior arguments are persuasive. For employers that see a lack of fairness in traditional three-month exercise windows, extended exercise windows may resonate as a progressive, employee-friendly policy, which can serve to signal company values, enhance culture and distinguish a company from its competitors. Longer post-termination exercise windows have been increasing in popularity, but are certainly not yet industry standard. Thus, extended windows may be a recruiting tool for companies seeking to demonstrate their employee-minded priorities.
Arguments Against Extended Exercise Windows
Argument 1: Crowded cap tables and administrative complexity
When employees are unable to exercise their options within the standard three-month window, they are forced to forfeit them, which means the shares subject to those options are removed from the cap table and returned to the pool. Without this “attrition,” natural to a stock pool with standard exercise windows, cap tables can become more crowded and complex, requiring that companies (or their lawyers) track additional exercise windows, for longer durations, which can lead to higher legal costs.
In addition to tracking a more crowded, intricate cap table, companies with extended post-termination exercise windows will face more nuanced tax and accounting implications. This is due to the fact that any option not exercised within three months of an employee’s departure is automatically treated by the IRS as a non-qualified stock option (“NSO”), for which the company has a withholding obligation upon exercise. Given the likelihood that NSO-holders will wait for a liquidity event in order to exercise their options, however, these tax and accounting implications may be no more complicated than those of restricted stock units or other common compensation structures used by growth companies today.
Argument 2: Nonstandard allocations and dilution effects (aka “option overhang”)
As a corollary to Argument 1, granting employees an extended period to exercise their options may require that founders, directors, and investors spend more time and energy rethinking equity allocations. Conventional wisdom around appropriate sizes of equity pools and employee grants reflects the recycling of unexercised options back into the pool for future employee equity grants, on the basis of a standard three-month window. With fewer shares recycled into the pool (as would happen in connection with an extended exercise window), there will likely need to be more frequent increases to the pool or perhaps smaller, but more frequent “refresh” grants. This all creates additional complexity, which may lead to unintended consequences vis-a-vis dilution and additional friction among the aforementioned stakeholders.
It is, of course, a bit of a tautology to say that solutions to issues posed by conventional wisdom will require rethinking the conventional wisdom, but, nonetheless, proponents of extended exercise windows should expect to engage with these issues around dilution caused by so-called “dead equity” in the hands of departed employees.
It may be challenging for first-time founders to distinguish the signal from the noise amidst the potentially complex implications of post-termination exercise windows, but there is value in prioritizing these considerations, as policies can be difficult, and costly, to adjust once established. Employee equity is one of the primary items in the toolbox for employers seeking to establish culture, promote fairness, and align incentives among employees in one fell swoop and, accordingly, should be given careful thought. Whomever a founder is engaging to discuss these decisions—be they co-founders, investors, or executive teams—the arguments above can serve well as a starting point for evaluating this important feature of the startup ecosystem.