For most high-impact businesses, equity incentive programs for employees are a central component of the total compensation plan. Giving employees “a piece” of the upside builds esprit de corps and compensates for some of the risks employees take when they sign on with a high-risk startup.[1]

Equity incentives usually come in the form of stock options. Typically, employees receive options to purchase a set number of shares of common stock at a fixed price. The options generally have a ten-year life; vest over time; and are priced at the best assessment of current fair market value at the time of grant (a discount to the preferred stock most recently purchased by investors). If employees leave before their options are fully-vested, the unvested options are forfeited and the vested options can be retained for a period. 

Well, sort of. And therein lies the topic for today’s blog.

As it turns out, most option agreements provide that if the vested options are not exercised within 90 days of the day the holder leaves employment they expire. Meaning, they are canceled – and of no value!

Consider this example (one somewhat close to my heart). An employee with a fully-vested option to purchase 50,000 shares at $12/share resigns. As is the general rule for incentive stock options, the employee now has 90 days to either exercise the option or let the option expire. To exercise the option, the employee must come up with $600,000 ($12 * 50,000 shares).

Now, if the company is public – that is, its shares are trading in the public market – the former employee can in effect use the proceeds of the sale of those shares to pay the exercise price. There is even likely a “cashless exercise” provision in the option to facilitate that. (We are assuming the public market price is more than $12/share, hence there is value to buying at the lower, $12/share price.)

But what if the company is still private, and there is no market for its shares? In that case, the former employee will almost certainly have to come up with $600,000 to exercise the option, and, when so exercised, the employee will own 50,000 shares of illiquid stock. Ouch. For most folks, the notion of coming up with $600,000 in cash to purchase an illiquid asset is, well, a non-starter. And so, the fully vested option expires and the former employee ends up with nothing.

The “exercise or forfeit” paradigm has always been problematic. But it has become even more so in recent years, for several reasons. First, in the “age of the Unicorn” startups are staying private longer, both in terms of time and valuation. Second, the number of employees leaving employment while they have vested shares and while the company is still private is increasing. Moreover, the exercise price of incentive stock options for later-hired employees are likely to be higher. Rule 409(a) – an SEC rule that took effect in 2005 has also led to higher option exercise prices by compressing the typical gap between option exercise prices and investor prices. These days, the assumption that the typical departing employee should be able to finance the exercise of her vested options out-of-pocket is no longer valid. 

So, what’s to be done?

The easiest fix is getting rid of the “exercise or forfeit” language in the standard option agreement. There’s a school of thought that after putting in the work to vest in the option, a former employee should not lose her option just because she can’t come up with the exercise price within 90 days of ending her employment – particularly if there is no public market for the underlying shares. The option is, on its face, almost always a ten-year option: make that a reality and give the ex-employee the full ten years to exercise.

Alas, the folks at the IRS – well, finally, Congress, actually – have a rule that provides that an incentive stock option that doesn’t include the “exercise or forfeit” provision on the specified terms for each specified departure (e.g., separation v. death) will no longer meet the requirements to be an “incentive” stock option. Rather, it will be deemed a “non-statutory” aka “non-qualified” stock option. And the tax implications of that – for the company and the ex-employee – are not good. For example, while an incentive stock option is not subject to withholding (e.g., payroll taxes), a non-qualified option is. There is some argument that not all incentive stock options are all they are cracked up to be (as they can still be subject to the dreaded AMT depending on the individual’s personal tax treatment), but we digress….

The market is providing certain solutions to this seemingly increasingly problematic problem. For example, several firms have entered the business of financing option exercises by ex-employees, usually in exchange for an assignment, by the ex-employee, of some portion of the exercised shares to the financing entity. This works but doesn’t seem, to me at least, fair to the ex-employee, who is still, in effect, losing “vested” options shares.

As noted, way back when companies achieved liquidity faster, and generally at lower valuations, the exercise or forfeit rule was not often very burdensome. Today, however, with startups staying private longer, and achieving higher valuations prior to exit, it’s becoming a real problem for many employees with incentive options. It’s something Boards should think about, and fix. Fixes can be easier said than done, but companies can get creative. Perhaps vetting restricted stock for early-stage companies, allowing for early exercise, and/or allowing for tender of owned shares to “pay” for the exercise price (and more) should be on the table…

[1] For readers interested in a more general discussion of employee equity incentive plans, see: https://bit.ly/3NFBO2Q