Commonly Considered Option Program Enhancements: Part III – Granting Options with Extended Post-Termination Exercise Periods

• 7.5.2023
• Ciara Baker, Kimberly Wethly

In this four-part series, we explore several of the most commonly-considered option program enhancements emerging companies may consider as they strive to make their stock option programs as compelling as possible to recruit and retain the critical talent necessary to build and grow their businesses.

Introduction

Unlike the complexities involved in granting early exercisable stock options (see Part 2 of the series), an apparently straightforward enhancement to any option program is to provide option holders with a longer-than-typical period of time in which to exercise their vested options after they leave the company. However, even here, the potential benefits to the option holder must be weighed against the consequences to the company.

As we described in Part 1, stock options are typically granted with a term of 10 years (or five years in the case of an incentive stock option (ISO) granted to a 10% stockholder). However, that term is cut short when the option holder terminates employment (or otherwise ceases to provide services to the company). Typically, the option holder has three months to exercise the vested portion of the option (or 12 months if the termination was the result of the option holder’s death or disability) and if the option is not exercised during that post-termination exercise period, the option is forfeited.

This effectively means that the former employee (or other service provider) must exercise the option within a limited period of time by paying the applicable exercise price and, if the option is a nonstatutory stock option (NSO), any applicable withholding taxes, or lose the option (and the right to purchase the company’s stock) entirely. When the option is only over a small number of shares or the applicable exercise price is low, the expense involved in exercising the option may not be an issue. But if the grant is large and/or the exercise price is high, it may be prohibitively expensive and/or risky for the option holder to exercise the option and purchase the company’s stock. For this reason, some commentators have referred to this limited post-termination exercise period as a “gotcha”: employees are lured to take below-market salaries from start-ups for the promise of stock options (and the potential for significant up-side) in the company but at the time of termination, they lose their ability to become stockholders and any appreciation in the company’s stock that they have helped to create.

Intended Benefits of Options Granted with Longer Post-Termination Exercise Periods

The potential benefit to the option holder of providing a longer post-termination period – which could be for an additional number of months, years or, indeed, for the whole of the original 10 (or 5) year term of the option – is clear. Rather than scrambling to raise the funds to pay the exercise price of the option (and any applicable withholding taxes), the option holder can either take the time to borrow or save a sufficient amount to exercise the option or, with luck, wait for a liquidity event to occur. And for its part, the company is able to leverage an apparently cheap but meaningful recruiting tool.

Countervailing Company Considerations

But. The potential benefit to the company must be weighed against the following considerations:

1. Tax Consequences and Administrative Matters. A stock option granted to an employee can still qualify as an ISO if it is granted with a post-termination exercise period that is longer than three months (or 12 months for terminations by reason of death or disability). However, under applicable tax rules, if an ISO is actually exercised more than three months (or 12 months in the case of a termination by death or disability) after the day the individual ceased to be an employee, it will be treated as an NSO. This means that if a former employee who voluntarily leaves the company exercises an option more than three months after terminating employment (which is presumably the point of providing a longer post-termination exercise period), there will be compensation income equal to the difference between the fair market value of the stock on the date of exercise and the exercise price at the time of exercise. As a result, the company will have to run payroll, withhold income and payroll taxes (which the former employee will have to provide) and, ultimately, issue an IRS Form W-2 reporting the income for the year in which exercise occurs. And this can be a real administrative headache (for example, if the individual is no longer on the company payroll, and particularly if the company has switched payroll providers since the employee was last on payroll). 

Speaking of administrative headaches, permitting an option holder to hang on to an option for longer also requires the company to keep in touch with that employee for longer – for address changes and the like. (Imagine, for example, needing to have a former employee sign an option cancellation agreement in connection with an acquisition). This can be difficult enough when the separation is amicable but when the separation is contentious, it can be quite fraught. 

2.  Share Recycling and Dilution. When a stock option is forfeited, cancelled, or expires, the shares subject to the option typically go back into the pool of shares available for issuance under the company’s equity incentive plan and can then be used to make new grants to recruit and incentivize new hires (including a former employee’s replacement) or existing employees. However, by providing for an extended post-termination exercise period, the shares that would ordinarily be recycled are in limbo—subject to an option that the option holder may or may not ever exercise. 

Without prompt share recycling, companies can be faced with the unhappy prospect of having to go to their stockholders to seek approval of an increase in their share pool which, in turn, results in higher levels of dilution. And the higher the level of dilution, the less likely stockholders are to approve the increased share pool. Without a sufficient share pool from which to make equity grants, recruiting may be difficult. So the very practice that is intended to be a recruiting tool, can instead thwart recruiting efforts.

3.  Potentially Undermines Retention Efforts. One of the many purposes of stock options is that they serve as a retention tool for employees – both through vesting and in cutting short the exercise period if the individual ceases to provide services. But providing a longer post-termination exercise period may prompt current employees with vested options to leave the company prematurely. After all, if they can hold on to their vested options for a longer period of time after termination, it is less critical that they stay in their seats to ensure that they can share in the company’s appreciation. 

4.  Consideration for a Release of Claims. One of the benefits of not providing for a longer post-termination exercise period as a matter of course is that it can always be provided (i.e., an outstanding option can be amended) on a case-by-case basis at the time an option holder leaves the company. While amending an outstanding option to extend the post-termination exercise period may cause an ISO to lose ISO status at the time of the amendment and generally results in an accounting charge to the company, if the extension is a new benefit at the time of termination, it can be used as consideration for the option holder to enter into a release of claims – which may be more affordable for a cash-strapped start-up that wouldn’t otherwise be able to make a cash severance payment. 

5.  Issues of Fairness. A case-by-case approach to providing an extended post-termination exercise period also allows the company to determine whether it is fair or appropriate for a particular option holder to get the benefit from future appreciation in value of the company when the award is ultimately exercised without having to pay the exercise price at the time of a termination of service. For example, it may be entirely appropriate for a key, early employee who was pivotal to founding the company or reaching a key milestone to get the benefit of future appreciation—even appreciation that the employee was not there to create. It may be less so for someone who spent a year at the company but ultimately has nothing to do with the success of the business. And this may be seen as inequitable by those employees who have stuck with the company throughout.

The extent to which these company considerations counter-balance the benefit to the option holders will, of course, be a function of both how long a post-termination exercise period is being considered (i.e., an extended post-termination exercise period of, for example, 6 months is a meaningfully different proposition than one that lasts for the duration of the term of the award) and how critical a benefit it is to recruit service providers in the company’s industry, hiring market and/or geographic location.

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Some companies attempt to solve the problem of prohibitively expensive option exercise prices (and too-short post-termination exercise periods) by providing loans to their employees to exercise their awards. In part four of this four-part series, we will dive further into the issues relating to permitting employees to exercise options with promissory notes instead of cash.