The Value of Employee Options

• 10.12.2015

One question almost all founders will run into—whether at the time of incorporation, when hiring their first employee, or just before raising the first round of financing—is how to structure the option pool and create incentives for employee recruitment and retention. 

Startups often find themselves in a fierce battle for talent, pitted against bigger, cash-flush companies that can offer higher salaries than startups can afford to pay. This is why equity incentives—in the form of stock options—are so popular from a recruitment perspective. They create a mechanism for the employees to participate in the growth of the company, aligning incentives and interests. 

A stock option is a contract between the company and an employee, consultant, advisor or other service provider. It allows the individual to buy a certain number of shares of stock at a fixed price, called the exercise price. The right to exercise the option will vest—typically, a four-year vesting period with a one-year cliff period. So initially, the holder cannot exercise any of the shares, but the number of shares that become exercisable will increase over time as long as the individual continues to provide services to the company. The holder of an option is not a shareholder until the option is exercised—until that time, the holder cannot vote on the shares and is not entitled to dividends paid on the shares. 

The exercise price of an option is typically set at the fair market value as of the time of the grant. This price is fixed—so even though the value of the stock may increase, the option holder gets to buy the shares at the earlier, lower fixed price. This is the key advantage of an option—the individual gets to wait and see how the company does before paying anything to buy the shares. It’s a case of optimistic capitalism. 

Types of Stock Options

There are two types of compensatory stock options in the US: incentive stock options (ISOs) and non-qualified stock options (NSOs). Companies can grant ISOs or NSOs to their employees, but cannot grant ISOs to non-employees. Therefore, companies can only give NSOs to contractors and consultants, advisors and non-employee directors. Read more about ISOs and NSOs.

Protecting the Startup

The stock option plan, option agreement or financing documents often have several employer protection provisions, including a right of first refusal if an employee wants to sell his or her shares, drag-along rights in connection with the sale of a company, and repurchase rights for stock that is exercised early and remains unvested at the time of an employee’s termination. 

Recently, the window in which employees can exercise stock options after termination has received a lot of attention. In a typical case where an employee voluntarily leaves or is terminated without cause, companies provide a one- to three-month window after termination to exercise the option. 

The Golden Handcuffs

With a one- to three-month window for an employee to decide whether to exercise, what does that window really mean for the employee, particularly when leaving a private company with no IPO or exit on the horizon? 

Inadvertently, employees might find they are bound by these golden handcuffs: either leave without exercising the options and lose the upside entirely; exercise and get a lower return than anticipated; or lose all their money if the company fails entirely. Employees can only exercise options if they have the cash liquidity (a big “if”) to pay not only the exercise price, but potentially also any Alternative Minimum Tax (AMT), i.e., the amount of (i) the fair market value of stock at time of exercise minus (ii) the exercise price. For many employees, that means selling the shares in the secondary market or back to the company in order to pay these obligations (which would be a disqualifying disposition and result in loss of the more tax-favorable ISO status). Companies sometimes block the secondary market sale through exercising their transfer restrictions, so effectively employees can only sell back to the company. 

These golden handcuffs, then, can benefit the company by:           

• Improving employee retention. Walking away with nothing or having to sell under restricted conditions can make it costly for an employee to leave, especially after putting years of work into a company that may have even gained significant value. In a market with fierce competition for talent, a company might think that such an incentive to get employees to stay is a good thing. But remember, this may not be the most effective tool to motivate highly talented employees to stay, and no one wants dead weight around, right?

• Less dilution of stock options. If the options are not exercised, they go back into the pool and become available for re-grant, so the current shareholders incur less dilution over the long term.

Releasing the Handcuffs

Especially at a time when private companies are delaying exits and valuations are going through the roof, it may seem unfair that an employee who leaves a company does not have a real choice when it comes to exercising stock options. Some companies have addressed this unfairness by: 

• Extending the exercise period. Quora, Pinterest, Coinbase, Asana and other companies have chosen to extend the period for employees to exercise their options, giving them years instead of months after they leave to decide whether to exercise. This allows employees some flexibility.
  
  But no matter how much time an employee gets, ISOs will convert to NSOs 90 days after employment ends if the options are not exercised before then. Still, having an NSO is better than nothing, and, may be no different in practice from having an ISO. (Check out this blog post on employee equity.)

• Permitting early exercise of options. Some companies have started to give employees the choice to exercise options early, soon after the grant. This means that the spread between the exercise price and the fair market value is not as high, lowering the AMT amount.

Both of these scenarios can get complicated. For example: 

• As a company grows, it usually relies on shares coming back into the option pool when employees leave, either because the options haven’t vested or haven’t been exercised at the time of termination. With an extended period for exercise, the company can no longer rely on these option shares becoming available, and might have to increase the size of the option pool (typically between 10%-20%) to make grants available to new employees. That would mean additional dilution for everyone.

• From an employee perspective, the extended exercise period sounds like a good deal. Even better in the case of an exit, right? Not always. With many more private companies acquiring other companies in stock-for-stock deals, the acquirer will also have to agree to assume the extended exercise period. Sometimes, honoring the extended period could mean adverse accounting treatment for the acquirer, to which it might not agree.

• Even if employees have the right to exercise options early, they will still have to pay cash to exercise the option. They will also have to exercise before having a full chance to evaluate the company’s future prospects. So early exercise of the option can often be a gamble, since there is always a risk of failure, particularly at the early stages.

• Liquidity risk becomes critical to option exercise decisions in later stage companies, and particularly early exercises. For a later stage company where valuations are running up quickly, there could be value to an employee in exercising early to start the clock on a long-term capital gains holding period. AMT or other tax liabilities can often come due at the time of exercise or within the next year, and due to lock-ups and other transfer restrictions, or a delay in the company’s ability to launch its IPO, employees will end up unable to sell stock to cover these anticipated tax liabilities.

• Finally, companies often underestimate the amount of additional administrative overhead with early exercise options. Employees may want or need to file 83(b) elections, stock certificates will need to be cut, tax filings may be required, the cap table will become more complicated and the company will need to remember to repurchase any unvested shares if the employee is terminated before the shares are fully vested. All of these hurdles can be handled, but companies need to be aware that they may need to invest additional resources in administrative overhead to take care of them.

Blog contributed by Eric Hanson