At many companies, particularly in the tech world, equity compensation is a crucial element in attracting and retaining top talent. However, the way that companies structure the terms of their equity plans can impact how valuable the grants are for recipients. As companies compete for the best workers, adopting employee-friendly terms can help them maximize value for staff and build a worker-centric reputation. Let’s dive into three strategies for company leaders to consider.
Increase Post-Employment Exercise Windows
One way to create an employee-friendly equity plan is to allow for longer post-employment option exercise periods. Option grants are often written to expire 3 months after the end of employment. This became the norm for most plans because, after 90 days, Incentive Stock Options (ISOs) convert to Non-Qualified Options (NSOs) under provisions of the Internal Revenue Code.
For many option holders, exercising while the award is still characterized as ISOs is smart because the tax treatment can be more favorable.1 But it’s important to note that there’s no requirement that option grants be structured to expire after 90 days, and sometimes a longer expiration period can be better for option-holders and companies.
With only a few months to exercise after a departure, many option recipients find that they don’t have the cash to exercise and end up losing their options, often giving up a substantial part of their compensation package. Others may find the funds to exercise but as a result, end up with much more of their financial resources allocated to a single investment than they’d like. Some employees will feel forced to remain at a company they would otherwise have left, which may seem like a win for companies aiming to hold on to staff with “golden handcuffs,” but in reality, can lead to a demotivated and inefficient workforce.
Recently, some companies are starting to reconsider the 90-day standard and building longer expiration periods into their plans. Pinterest may have kicked off the trend when it announced in 2015 that it would give employees leaving after 2 years of service 7 years to exercise. More recently, Gusto highlighted its 10-year option expiration term. And, in the many rounds of layoffs in recent years, companies like Brex have made a point of extending option exercise periods for laid-off employees.
Rethink Unnecessary Restrictions and Facilitate Employee Liquidity
It’s become common for companies to enact strict transfer restrictions in bylaws, equity plans, and other company agreements. There is reasonable thinking behind these restrictions, as rampant sales can lead to out-of-control cap tables and secondary trading may push up a company’s 409A valuation (making exercising stock options more expensive for employees).
However, these restrictions can inadvertently become overly burdensome or complex for employees to navigate, leading to frustration and uncertainty. This can be especially problematic as the timeline for an IPO or exit extends for many companies. An overly restrictive approach can also appear unfair, since many companies will facilitate liquidity for limited executives through secondary sales.
To address these issues, companies should reconsider the scope of their transfer restrictions and explore employee liquidity opportunities. Some liquidity approaches, such as structured secondary solutions or alternatively, loans, can give equity holders liquidity without shares changing hands, avoiding cap table concerns.
Companies can also consider offering periodic tender offers, whether in the form of a purchase from the company or by a vetted investor, which allows employees to access liquidity on consistent terms and gives the company control over the process and ownership. Another option is to create a process for reviewing and approving secondary sales, though that approach can be administratively burdensome. With a menu of options to choose from, companies should be intentional in how they both restrict and facilitate, employee liquidity.
Allow For Early Exercise
Traditional options are granted with a vesting schedule, and the recipient can only exercise shares once they’ve vested. That structure can cause option-holders to lose out on potential gains if the value of the shares increases over time. When an option-holder exercises options, they’re often taxed on the difference between the strike price of the options and the current fair market value of the shares, either in the form of AMT tax for ISOs or at ordinary tax rates for NSOs. Any further gain between the exercise price and a future sale price is generally taxed at capital gains rates, which are most favorable when the shares are held for over a year.
Early exercise grants allow the recipient to exercise options before they’ve vested, with the company receiving a repurchase right over any shares that don’t ultimately vest. This allows the holder to exercise when there’s minimal gain, reducing the initial tax impact and increasing the likelihood that future gains will be taxed at lower long-term capital gains rates.
However, early exercise might not suit everyone. If the strike price or current fair market value is already high, exercising can still be costly, especially when the company’s future success is uncertain. Many early-stage companies fail, potentially rendering exercised shares worthless.
However, granting employees the ability to exercise their options early can be a game-changer for both sides. Bullish employees can capitalize on the company’s potential by exercising options at lower costs. From the company’s perspective, early exercise transforms option-holders into shareholders at an earlier stage, which can foster a deeper commitment to company success among staff. This employee-friendly move demonstrates the company’s concern for its workforce and aligns the interests of employees with the long-term growth of the organization.
Employee Friendly Equity Terms Are Paramount
For companies aiming to attract and retain top talent in today’s competitive landscape, these equity terms can be key: extending post-employment exercise windows, rethinking unnecessary restrictions to facilitate employee liquidity, and allowing early exercise options. Companies can significantly enhance the value of their equity incentive plans. These initiatives not only provide employees with greater financial flexibility and opportunities for wealth accumulation but can also encourage employees to be more dedicated to the company’s growth and success.
At Liquid Stock, our solutions are tailored to meet your specific goals and needs. Reach out to our team to discuss unlocking your hard-earned equity, today.
1. For NSOs, upon exercise, the difference between the option exercise price and the current fair market value of the shares is typically taxed at ordinary income rates and that tax is withheld by the company in connection with the exercise. For ISOs, the option holder typically won’t owe taxes immediately upon exercise, though they may face Alternative Minimum Income (AMT) tax on the gain later in the year.
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