My Big Rethink Part 3: Rethinking Employee Option Exercise Policies

This is the third in a series of posts related to rethinking governance and compensation practices at venture-backed technology companies. My perspective is formed by 35+ years of running and investing in these types of projects where I have helped create wealth for investors, founders, and employees. Previously, I have written on the importance of protecting employee representation on boards as companies grow and on ensuring fairness in policies around secondary sales of stock. Here I want to discuss some simple changes to employee option agreements that can make a big difference.

Equity options are a key component of employee compensation plans at venture-backed startups. They are most always the primary incentive that makes up for the fact that startups can’t offer the same cash or perks as larger companies. Equity options are the most obvious path for creating wealth for most technology workers. It is time that we rethink a standard component of employee stock option plans - the exercise period.

When an employee exercises their options, they pay the strike price and take ownership of the shares of the company’s common stock; but if a company is not public, there is no opportunity to sell that stock at the market price. Nevertheless, the employee bought an asset that has a different value than it had when the strike price was set. If that value is higher than the strike price, the employee may have tax liability for the gain between the original strike price and market value at time of exercise.

The beauty and value of options are that you get to decide if and when to exercise - giving employees the flexibility to make the economic choice that works for them. However, the IRS requires that incentive stock options have a maximum of 10 years before an option expires. As such, most companies’ option agreements include this 10-year expiration. For companies that remain private but continue to increase in value, as evidenced by raising additional funds at higher values, the value of the stock subject to the option may increase dramatically even if the stock is still not liquid.? So an employee who exercises an option at a time when there is significant “spread” value must pay not only the exercise price but also any tax liability. This is can be a big bet - and often a very expensive bet. I’d like to see companies recognize the tough spot that employees are put in by replacing any options that expire with new grants – that perhaps require limited continued service to vest (e.g., a year) – with slightly higher share numbers to make up, at least partially, for the value lost when the option expired.

The second part of this Rethink is around exercise requirements after leaving the company. Most agreements have something like a 90-day period after an employee leaves - whether voluntary or not - to exercise. Similar to the case above, this can put employees in a real bind as they decide how to fund the exercise and how to cover the tax liability when the timing or liquidity and ultimate value of their shares are unknown. This is going to be an extremely common scenario as we see unicorns retrench and trim their workforces as they navigate the current downturn. I’d like to see companies extend the exercise period substantially for vested options - say 12 to 36 months after leaving a company in good standing. This would provide significant flexibility for an employee to plan and make a more informed decision about whether to exercise.

Option vesting schedules are designed to retain talent. But once an option has vested, in my view it has been fully earned and should be treated like the property of the employee. They should have the flexibility to realize value from their work and dedication. Changing equity incentive programs in this way would increase the attractiveness of equity grants and will differentiate those companies that embrace the concept.