The Gift Startups Should Definitely Not Give Their Employees
NOTE: This article by former Counsel John Demeter originally appeared on The Experts blog on WSJ.com on November 24, 2015.
As the founder of a startup, you’d love to reward your employees with hefty holiday bonuses, but your business is bootstrapped and cash is, undoubtedly, in somewhat short supply.
So you might be looking for holiday gifts that telegraph yet don’t break the bank.
Here’s the solution that many founders are coming up with: They are giving employees the gift of extra time to exercise their vested stock options after they leave.
Before you join the crowd, let me say this: It’s a terrible idea on every level.
Believe me, I understand the attraction. It doesn’t cost a dime, and this act of generosity gives departing workers extra time to pull together the cash to buy shares that could one day a significant reward.
It’s no wonder that I’m seeing more and more ex-employees asking for extensions to exercise their vested options beyond the standard 90 days. And I’ve heard from an increasing number of company executives who are stretching these windows to 180 days, two years and even five years. It’s not yet the norm, but such extensions are more common than ever before.
Wanting to give ex-employees more time to exercise their vested options is an understandable response to the rising valuations of companies. Five years ago, it was exceedingly rare to see a startup valued at $500 million stay private or spurn acquisition offers. Facebook thumbed its nose at those choices, pocketing private capital until its $100 billion IPO in 2012. Ride-share app Uber is valued at nearly $51 billion, thanks to a steady diet of VC cash. Even if Square’s impending IPO valuation is “just” $4 billion—about $2 billion less than its last valuation—we’re still talking about a staggering amount of money.
In short, companies are waiting longer than ever before to go public and rebuffing offers to be acquired, and all the while, their valuations keep climbing. That’s not an issue for their current employees. They can wait to exercise their options until the ultimate event. But ex-employees face a predicament: They forfeit their right to hard-earned vested equity if they don’t exercise their vested options within 90 days of leaving the company—but exercising those options might cost them five or six figures if their company has a significant valuation. The result is that the very people who helped the company achieve a level of success may not be able to afford the price of admission to benefit from it.
I can understand why sympathetic founders would want to be gracious to departing hard workers who helped the company grow.
But what appears to be an act of generosity can sabotage recruiting efforts. After the 90-day period to exercise expires, unexercised shares typically go back into the employee equity pool to be dangled before promising recruits or reward hardworking employees, but once you extend the period to exercise, these shares are in limbo. That leaves you with a smaller pool of available options in a competitive market with high turnover, and that can affect your ability to hire and retain new talent.
Some of my clients have toyed with the idea of permitting their departing employees to buy shares with a promissory note instead of cash. Upon a event when the shares’ value exceeds the amount of the IOU, the ex-employees repay the loan and pocket the gain. But what happens if the stock price tanks—or the startup folds and the debtor refuses to pay? You can wind up in the very awkward position of a creditor, pursuing the very folks you had wanted to help.
Waiving that 90-day deadline on a case-by-case might appear to be a safer option. Perhaps, for example, you’d make an exception for your first employee, who put in untold hours to grow your business a hundredfold. But you risk creating a human-resources nightmare by appearing to play favorites. If you are playing favorites, your business can easily run afoul of state and federal anti-discrimination laws. And when your current workers learn about these exceptions—they somehow always do, don’t they?—you’ll undermine morale and trust.
There may be another unintended consequence of extending the exercise deadline: It could prompt your current employees to leave the company prematurely. Because they can benefit from the value of their stock options whether they remain with the company or not, you’re sending a message that they might as well move on.
So don’t bend the rules. This advice may not be popular, but it does protect you and your business. Your ex-employees were excellent workers, but they’ve moved on. Of all the people connected with your startup—your current team, your investors, your co-founders—your former employees are the least engaged in its future. Why put your company’s fate on the line for people who are no longer invested in it?
A stock-incentive plan rewards the folks who are invested in your success. Do what you can to keep them happy and productive while they’re on your payroll. When they leave and you want to show your gratitude, give them a gift card. Give them wireless speakers. Give them a giant of artisanal fair-trade coffee.
In short, give them anything but extra time to exercise their vested options.