Startup stock options: Opportunities for improvement
Startup stock options: Opportunities for improvement
Facilitating ownership and liquidity options
The previous two posts in this trilogy covered the basics of stock options and explored different sources of selling private company shares. This post will cover what I view as some of the main limitations of traditional startup stock option incentive programs and manners in which they can be improved.
Recall, that we explored several obstacles that an stock option holder has to navigate. These are the following:
Potential tax liability (AMT) at the time of exercise.
Limited time window - typically 90 days - to exercise shares upon leaving the company
Company rights and preferences when attempting to sell shares.
When looked at in aggregate, these constraints, force employees to pursue one of these two choices.
First, they can elect to exercise their shares, but in doing so will be spending capital to exercise their options. They might also be spending even more capital in the form of tax. Finally, because of the illiquid nature of private shares and company restrictions on selling private shares, the employee might not be able to sell her shares. This choice can be summed up like so.
Cash out, and potentially no cash in.
The second choice is for the employee to not exercise her shares. However, this option might imply that the employee cannot leave the company. Should she leave, she’s now forced to exercise her shares in no more than 90 days post leaving the company. We’re back to the first choice. I therefore refer to this choice as “Hotel California”
“You can check out any time you like, but you can never leave” Hotel California, The Eagles
Neither of these choices aren particularly appealing to employees, which is why I believe that stock option inventive programs should. be adjusted in favor of enabling employees to own, and potentially sell, their shares. There are three changes I would like to see adopted
Early exercise
Early exercise allows the employee to exercise her options before they vest. This can be very advantageous for both (lower) tax purposes and to capitalize on a low strike price. This option allows the employee to own her shares whilst preserving capital. You might see a clause like this one - which is illustrative - in your stock option agreement
Early Exercise. The Award Agreement may, but need not, include a provision whereby the Grantee may elect at any time while an Employee, Director or Consultant to exercise any part or all of the Award prior to full vesting of the Award. Any unvested Shares received pursuant to such exercise may be subject to a repurchase right in favor of the Company or a Related Entity or to any other restriction the Administrator determines to be appropriate.
This option is not without its risks though. Consider the case whereby an employee purchases all her unvested shares and decide to leave 1 year later. First, the employee has to return the portion of shares that she exercised yet are still unvested. Those will be shares that vest in years 2-4, assuming a 4 year vesting program. Second, the tax that the employee paid when she exercised all her shares cannot be reclaimed.
Generally speaking, having this option is far better than not, in spite of the tax risk.
Longer exercise window
I can’t stress enough how I dislike the default 90 day exercise window. To recall, most startup equity incentive plans give employees 90 days post leaving the company to decide whether they want to exercise their options or not. This period need to be far greater than 90 days.
Thankfully, companies are now starting to offer exercise windows that are greater than 90 days. The length of these exercise window can vary depending on the company's policies and practices. Some companies may offer 6 months, 1 year, or even longer exercise windows to give employees more time to exercise their options after leaving the company. I’ve seen exercise windows as long as 10 years.
Facilitating transactions
The previous two changes I proposed do not require investors of the company to invest in anything other than the additional burden of tracking unvested shares in the case of early exercise. Even that is minimal now that we have Carta and similar equity management software.
This next proposed change is meant to common shareholders the ability to sell their shares on secondary markets or via tender offers, which are oftentimes only available to company founders. This option can be offered ony to long tenured employees and perhaps aligned with company fund-raising events. The intent though, is to offer the same liquidity options that are often times reserved to founders only, and sometimes with spectacular consequences. Consider the case of Hopin’s founder being allowed to cash out, only for the company to perish 2 years later.
These changes that I propose are meant to encourage employee long-term ownership of company shares which is aligned with the incentives of investors and founders alike. But they also recognize that life happens. Employees might need to move or change jobs due to major life events. They need not have to forgo their shares when that happens. Similarly, they might need to sell their shares to purchase a home, send kids to college or many other reasons.