Stock options remain the best-known (and, sometimes, the only known) equity vehicle for compensating employees.
Despite their imperfections, in our view, for two principal reasons stock options remain the standard equity incentive vehicle for high–growth startups and many emerging growth companies (as well as some public companies). First, the exercise price of a stock option sets a “watermark” or “threshold” that provides an easy mechanism for distinguishing which holders participate in which slices of the equity value of the issuer company. That is, the exercise price requires an option holder to buy his or her share of the equity value that pre-dated the option grant, preventing earlier equity holders from suffering dilution of that pre-existing value by reason of the option grant (i). Second, stock options are taxed in an unusual manner relative to most forms of compensation: the recipient of a stock option pays no tax upon grant and, subject to some important caveats, generally can choose when to be taxed on any compensation attributable to the option (i.e., by exercising the option). There are, of course, other reasons options are used in lieu of other equity incentive vehicles in particular situations.
One of the main drawbacks (ii) of options for private company issuers and grantees are the liquidity issues associated with exercising them. To exercise an option, its holder is commonly, if not almost always, required to deliver to the issuer company, in cash, both the exercise price for the option and the amount of withholding taxes due upon exercise of the option. Under the U.S. Tax Code, the amount of the withholding tax due upon the exercise of a non-qualified stock option (“NSO”) (the most common type of option) is a defined percentage of the “spread” value of the NSO (i.e., the amount by which the fair market value of the shares subject to the NSO on the date of exercise exceeds the exercise price for those shares). The greater the appreciation in value of such shares, the more difficult it is for the option holder to afford to exercise an NSO granted by a private company. Further compounding the problem, the withholding taxes triggered upon an option holder’s exercise of an NSO may be less than the ultimate amount of income tax that is due in connection with the option exercise, giving rise to yet additional “dry tax” obligations for the year of exercise (iii).
Most options include a 10–year term, giving an extended window for an intervening liquidity event that mitigates this option-exercise conundrum, assuming the option holder continues to be an employee for that entire period (and further assuming that the liquidity event results in cash or marketable securities – not all “liquidity events” do, of course). However, the realities of the labor market dictate that that type of tenure is exceedingly rare, and the cost-of-exercise problem commonly arises when an option holder terminates employment with the company (voluntarily or involuntarily) at a time when the embedded spread on the holder’s option(s) is a relatively large sum (which, after all, arguably reflects the realization of the entire purpose of equity compensation — providing an incentive aligned with significantly increasing the equity value of the issuer company!). Despite this reality and dynamic, most stock options include only a relatively limited post-termination exercise period (“PTEP”), which is commonly approximately three months for most typical termination situations (either a resignation by the option holder or a termination of the option holder’s employment by the company without “cause”) (iv).
This is not a new problem. Silicon Valley and sophisticated emerging growth companies have grappled with this issue for years, particularly as runways to initial public offerings lengthened during the post-“Dot Com” bubble period. The issues were then exacerbated by the post-2008–financial–crisis boom in tech companies, as high valuations made for acute liquidity problems associated with option exercises. Ed Zimmerman and Jim Gregory of Lowenstein Sandler LLP admirably explored the tax and commercial issues around extended PTEPs in a 2017 Forbes article. While 2022 put an end to the market’s most recent bull run, this issue nonetheless persists for many companies and will regain greater salience more broadly, once again, as equity prices start to climb again.
Although extended PTEPs have gained some favor in recent years, this approach remains the exception rather than the rule. For companies wishing to distinguish their programs more broadly, or attract key talent in specific instances, there are multiple approaches that could be considered for mitigating the cost-of-exercise problem. The table below summarizes certain possible PTEP approaches, ranging from very simple to creative and complex (v).
While the first two alternatives in the table above are more common in the market, to our knowledge, alternatives 3, 4 and 5 have not seen widespread adoption. Nonetheless, for companies comfortable being on the “cutting edge,” each (or a combination) of the above alternatives may be worth considering — the market can and does evolve! — as each alternative can provide a sophisticated way of splitting the option-exercise liquidity risk between an issuer company and an option holder (and help companies and their talent reach more equitable deals that enable talent to participate in equity value they have presumably helped create for the benefit of all equity holders).
Of course, there are numerous legal, tax, accounting, commercial and communications nuances that need to be worked through for any PTEP extension design chosen. If these issues are on your mind, please feel free to contact us.
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(i) This is a simplification. Many high-growth private companies organized as “C” corporations will issue preferred shares to investors with a liquidation preference (generally equal to their original investment). Because of the liquidation preference, the preferred shares are more valuable than the common shares subject to a typical stock option. Even if the total equity value of the company has been determined (such as through an arm’s-length negotiation with an investor), companies frequently engage valuation firms to determine how much the company’s common stock is worth. Generally, those independent valuations assign considerably less value to the common stock than the preferred stock — despite the fact that, if things go well, a common share may have the same value as a preferred share in the future — to account for the risk that things may not go well (in which case the common shares are less valuable than the preferred shares due to the “downside” protection of the liquidation preference associated with the preferred shares). Those valuations are commonly used as the basis for setting the strike prices of NSOs under Tax Code Section 409A (and for “incentive stock options,” or “ISOs,” qualified under Tax Code Section 422).
(ii) This is generally a “drawback” in the eyes of the option holder. Some issuing companies (and their other stockholders) consider this a “feature” and not a “bug” because the liquidity pressure makes it more likely that departing employees will simply give up the value and future upside of vested stock options because they cannot afford the cost to exercise the stock options into shares. Other companies, however, do not view the world that way, at least not in every case (or, at a minimum, worry that a candidate for employment will not join the company in the first place, or that their employee base will both notice and understand this issue and discount the value of their stock options accordingly ).
(iii) In the case of ISOs, no tax withholding is due at exercise. However, there can still be “dry tax” issues due to the alternative minimum tax (or “AMT”). Furthermore, because some of the conditions for ISO treatment may not ultimately be satisfied in practice even if an award is intended to be structured as ISOs to the extent possible, it is frequently the case that all or some portion of an award of ISOs will nonetheless take the form of NSOs upon settlement (e.g., in connection with a liquidity event) or otherwise (e.g., because of the $100,000 per year first-exercisable limitation).
(iv) If an option grant includes ISOs, ISO status is preserved under the applicable tax rules, in most cases, only if the ISOs are exercised within three months following termination of employment, even if a longer PTEP gives the holder a choice to exercise some time after the three-month post-termination window.
(v) As Zimmerman and Gregory note in their article, there are also other approaches to addressing liquidity issues associated with option exercise. Among the alternatives are providing option holders periodic opportunities to participate in secondary transactions, implementing a partnership holding company and issuing profits interests in lieu of options, issuing “liquidity event” (sometimes called “Facebook style”) restricted stock units (or “RSUs”) in lieu of options, and providing company loans to purchase restricted shares (in lieu of issuing options). “Early exercise” NSOs, under the right circumstances (and often with significant complexity and numerous commercial, legal and tax terms to address), can also provide a viable approach. Each of those approaches has its own merits and demerits (both from the perspective of the company and the employee) — there is no “magic bullet” to solve this problem.