Recommendations for Startup Employee Option Plans

This post presents our current recommendation for how tech startups should structure employee stock incentive programs.

I recently wrote a post about the potential issues associated with switching from a 90-day post-employment exercise period to a 10-year exercise period for employee stock option grants. While the goal of that post was to surface a number of considerations founders should take into account if contemplating such a switch, many people interpreted the post as a statement against 10-year exercise periods. This was not our intention, so I want to be clear about our overall position as a firm.

While everyone wants to do what’s best for the lifeblood of the company — the former, current, and potentially future employees — the 90-day exercise essentially pits cash-rich employees against cash-poor ones. And that isn’t right. Employees who have vested their hard-earned options should not have to forfeit their stock simply because they don’t have the financial resources to exercise their options and pay the resulting taxes.

So, we propose an option program here that includes 10-year exercise periods, and we encourage founders to consider a comprehensive program that aims to address the following issues that may then result from that:

• Inadvertently incentivizing employees to quit — If an employee has been at your company for, say, 2 years and has the opportunity to join a new company, she has an interesting financial decision to make. If she stays at the company and it fails, she loses everything. If she leaves and your company succeeds, her upside is protected by the 10-year option to exercise 2 years of options plus she protects her downside by acquiring stock in a new company. Even if she likes your company much better, she still has a fiduciary responsibility to her family to do what’s best for them, and in many cases the rational thing will be to create diversification and thus go to the new company.
• Potentially creating legal risks for ex-employees — Since companies are staying private longer, ex-employees who want liquidity may turn to the private secondary market to sell their stock or pledge their options to a third party. It’s long settled under federal securities laws that the seller can be liable to the buyer if he knows information that could affect the value of the stock and that information is not disclosed to the buyer. For example, if he knows (as a result of having been at the company) that the prospects of the business are looking grim or a product launch is significantly delayed, that’s important information a buyer would deserve to know in evaluating whether to buy the stock, and failure to disclose that information creates real legal jeopardy for the seller. Although we haven’t yet seen the SEC challenge many secondary sales to date, Mary Jo White, the Chairwoman of the SEC, recently gave a talk at Stanford where she hinted that the SEC is going to take a closer look at secondary stock sales. This risk exists in a 90-day exercise program as well, but it becomes a lot more acute when you move to 10-year exercise periods. Mitigating it is a good idea regardless of which exercise period you choose — and it’s not only good for your employees, but will also help protect the company from potential legal problems.
• Making critical shareholder votes more difficult — When you need to make changes that require approval of the common shareholders, you will now have many more shareholders to track down. Shareholder votes can impact critically important situations such as acquisition offers, new share authorizations (to issue options to employees!), buying companies, and raising money. If you have to round up thousands of shareholders to take corporate actions, your job as CEO becomes much more difficult. Slowing down these kinds of transactions may put the transactions and potentially your company at risk.
• Inferior tax treatment for employees due to the difference between the two types of options that companies can grant employees, Incentive Stock Options (ISOs) and Non-Qualified Stock Options (non-quals) — ISOs have better tax treatment for employees because the employee does not have to pay taxes at the time of exercise on the difference between the exercise price of the option and the fair market value of the stock. But under current law, if an employer moves to a 10-year exercise program, ISOs become “disqualified” and automatically convert into non-quals if not exercised within 90 days of employment. Thus, the employee will receive the less favorable tax treatment under the longer exercise period.

Here is a stock option plan that we believe offers the fairer 10-year exercise period, while also mitigating the consequences of the above issues:

10-year option exercise period
This enables employees who do not have the money to purchase their options and pay the corresponding taxes at the time of their exit to get the full benefit of their vested options. As noted above, however, under current law, this would mean that all options would be non-quals (not ISOs).

Back-end loaded stock vesting
By using a back-end loaded vesting schedule, you greatly mitigate incentives to quit. There are many ways to do this, but one example is what Snapchat does: employees vest 10% in the first year, 20% in the second year, 30% in the third year, and 40% in the fourth year. In lieu of a back-end loaded vesting schedule, companies may also consider minimum tenure requirements for the 10-year exercise window to kick in or a sliding scale where time to exercise increases with employee tenure.

Transfer restrictions
Strong stock transfer restrictions will protect the company, its employees, and its ex-employees from any potential hazards associated with secondary selling. Among other things, transfer restrictions force the company to be an active party in any secondary selling issues and thus more likely ensure that all proper disclosures are made to potential buyers, relieving legal liability on employees and controlling who ends up owning the company’s private stock. Particularly with the SEC’s new focus in this area, companies should think this issue through very carefully. To be perfectly clear on this, these same transfer restrictions should equally apply to founders and all investors; these risks are not employee-specific, but are simply magnified if you have lots more ex-employees with vested shares.

83(b) for early employees
There is a simple, existing, employee-favorable mechanism that requires no changes to option plans, at least for early stage companies. It’s called 83(b), aptly named for the IRS Code section that describes the provision. An 83(b) election allows an employee to early-exercise her options even before they have vested. The employee comes out of pocket for the cost of the exercise price (why this solution works for early stage companies only, where the common stock valuation is very low) but does not owe any taxes (this is because the exercise price and the fair market value of the stock are equal). An 83(b) election also confers another tax benefit: it starts the clock ticking on the long-term capital gains holding period, so when the employee sells the stock, she is likely taxed at the lower capital gains rate only. Granted, this doesn’t solve the problem for all employees, because as the exercise price of the stock goes up, later-hired employees would have to be able to afford much higher amounts of cash to do an 83(b) election. But we encourage the use of the 83(b) mechanism for early employees.

Moving to RSUs as valuations materially increase
Restricted Stock Units (RSUs), unlike options, don’t have an exercise price. Thus, there is no out-of-pocket cost for the employee to get the benefit of the RSU and there is no risk of RSUs being “out of the money” — RSUs always have value equal to the price of the stock regardless of when they were granted to employees. RSUs thus not only help solve the 10-year exercise problem (as long as they are structured properly, there are no taxes at the time of vesting), but they also sidestep other issues such as stock-price fluctuations that could cause options to go underwater and be worthless. However, because the math of options says you typically issue about 1/3rd the number of RSUs as stock options to employees, it’s best to wait until the intrinsic value of the RSU is high enough that such a tradeoff makes sense for employees. There’s no magic number here, but in general as companies get to $1+ billion valuations and the issues with options become more intense, switching to RSUs makes sense. Unlike options, RSUs generally can’t be sold prior to an IPO, so they don’t offer an interim liquidity solution for employees, but, given the heightened legal risks associated with secondary selling generally, this is still a reasonable trade-off in the current environment.

Closing considerations

The decision to adopt a 10-year exercise program, as with all aspects of a compensation strategy, is highly company-specific; each company should go through its own idea-maze for what plan best suits its overall culture and goals. Compensation is a foundational philosophy and a core part of a company’s culture — no different from other aspects of culture that companies seek to foster — and should be well thought out and consistent with the objectives and culture of the overall organization.

Furthermore, the decision also depends on the type of company you’re building and therefore the types of skill sets for which you are optimizing. For example, as a hardware company where long-term knowledge about infrastructure matters, Tesla may value longer tenure than other companies and thus might design a program around this specific goal.

So, there is no one-size-fits-all approach.

And whatever plan you choose, it is likely to morph over time as the environment changes. For example, there is a proposed bill in Congress right now (the Warner-Heller Bill) that would solve one half of the current option problem — by deferring for up to 7 years the taxes owed by a private company employee at the time of option exercise. While this bill is in the early stages of making its way through Congress, the point is that this situation is highly fluid so make sure your plans can accommodate any such policy changes.

The broader liquidity environment will play a role as well in how long the exercise period should be. We are here because companies are choosing to stay private significantly longer than the time period for which the 4-year option vesting program was originally designed. So, this current recommendation works in an environment where time to IPO is about 10 years. To the extent this time period shrinks, founders may want to move to a shorter period more closely tied to the average time to liquidity.

Most importantly, no matter what plan you implement, be completely transparent with employees — at the time of hiring — about all of the issues surrounding your compensation program. Among the feedback I received on the earlier post, I was struck by how many employees felt the 90-day option expiration window was never mentioned to them when they joined the company and thus was a complete surprise when they first learned about it at exit. If hiring managers are failing to be clear and transparent with employees about any aspect of compensation, this is an enormous mistake that fundamentally compromises trust between employer and employee.

The existing plans, while flawed, have been around for many decades, so the issues are well known. New plans will surely generate new issues, so design your plan carefully and to be consistent with the goals and company culture you want to foster.

 

Thanks to Adam D’Angelo, Sam Altman, and the founders and former startup employees who shared their thoughts and also read earlier drafts of this post.