Digital pegboard company Pinterest made big waves in the startup community by announcing that it would allow employees with at least two years of tenure to keep their vested stock options for up to seven years after they leave the company. By removing the standard 90-day post-employment option exercise period on most departing employees, Pinterest has made it far easier for its employees to keep their stock options if they leave for a new job.
What does this mean?
That’s the question we’re getting here at Founders Workbench, so we wanted to take a look at this from our perspective as advisors to startup company founders that often aspire to the kind of rapid business growth Pinterest is experiencing. We hope the following analysis of the background and legal implications of this decision provides helpful guidance in determining the merit of a program like the one Pinterest’s recently announced.
Not the First
Pinterest is not the first company to take this approach. A few other late-stage, highly-valued companies have done the same. Quora, for example, developed a plan last year that is similar to Pinterest’s. While it is still too early to predict whether this will comprehensively become the new normal, it represents a solution to the compensation challenge facing fast-growing startups that are staying private for longer periods of time. Indeed, “unicorn list” companies are pushing IPOs off until much later in their business trajectory, and companies like Pinterest are responding to this new dynamic.
Stock Option Plans
Nearly all stock options issued by private companies have a ten-year term, meaning that the option will expire if it is not exercised within ten years after it was granted. The prevailing default, however, has been to cut this ten-year term short if an employee leaves the company before the end of the term. Most private companies grant incentive stock options (ISOs) – which are eligible for favorable tax treatment if certain conditions are satisfied. One of the ISO rules is that the option has to be exercised no later than three months after employment ends. If not, the option is no longer an ISO and will be taxed as a non-statutory option (NSO). As a result, a 90-day post termination exercise period has been the norm.
It is completely possible under most standard stock option plans to grant an option with a longer post-termination exercise period, or to not cut short the option term at all if an employee leaves the company. Therefore, companies could easily grant options that are exercisable for up to ten years regardless of whether the employee stays at the company after vesting. Moreover, an ISO could be granted with this feature and it could maintain ISO status (if desired) as long as it is exercised within (or before) three months after employment ends – after that time, the option would automatically convert to an NSO. Note that tax rules limit the life of an ISO to a maximum of ten years from the date of grant in any event.
Previously granted options could be amended to remove or lengthen the post-termination exercise period. Doing so, however, would convert an ISO to an NSO at the time of amendment under the ISO rules. It is important to remember that tax rules generally prohibit an option’s term from being amended past the ten year anniversary of the grant (or the original term, if shorter).
For your reference, here are the key tax differences between NSOs and ISOs – assuming that the option is exercised after vesting (i.e., not “early exercised”):
|
|
NSO |
ISO |
|
Tax result to optionee at grant |
None.* |
None.* |
|
Tax result to optionee at vesting |
None. |
None. |
|
Tax result to optionee at exercise |
Ordinary income equal to spread (if any) on all exercised shares. Subject to tax withholding and payroll taxes for employees and former employees. |
Spread (if any) on all exercised shares subject to AMT. |
|
Tax result to optionee on sale of shares acquired by exercise |
Long-term or short-term capital gain on appreciation over basis (basis = FMV at exercise). To be eligible for long-term capital gains tax, must hold shares for at least one year after exercise. |
Possible long-term capital gain on all appreciation over exercise price. To be eligible for long-term capital gain, must hold shares for the longer of one year after exercise or two years after grant and satisfy all other ISO requirements. If don’t satisfy holding period, there is a “disqualifying disposition,” with ordinary income tax due on difference between exercise price and FMV of stock at time of exercise and long-term or short-term capital gain on appreciation over basis (basis = FMV at exercise). |
* Adverse tax consequences under Code Section 409A and lose ISO status if exercise price is below fair market value.
The Pinterest Decision
Pinterest chose to provide this benefit so that former employees would not be forced to quickly come up with the exercise price and/or suffer the tax consequences on exercise as described above. Earlier stage companies often avoid this concern because they typically grant options with a relatively low exercise price and also give employees the opportunity to “early exercise” their options. Early-exercise options allow employees to exercise shortly after the option is granted and before the stock has appreciated in value. If the employee makes a timely 83(b) election with the IRS, he or she can also lock in that lower value for tax purposes thereby limiting, or even eliminating, the income tax or AMT normally due in connection with exercises. In addition, the 90-day post-termination exercise period becomes irrelevant for options that are early exercised.
The Pinterest approach may make sense for certain later-stage companies, especially those with high valuations. Alternatively, some companies may want to provide this benefit to departing employees on a case-by-case basis. Granting options with a longer post-termination exercise period and/or amending existing options to remove the post-termination exercise period can have major legal and practical results, however, that are worth bearing in mind. Here are some pros and cons that should be considered:
Pros
- Improved company morale and culture: Employees will likely view this as a highly favorable and equitable move because they are liberated to leave the company without having to immediately pay for options and taxes.
- Recruiting: Companies offering this benefit should have an edge in bringing in talent.
- More leeway: Less pressure to facilitate secondary sales or implement employee liquidity programs
- Greater flexibility: If included in terms of new grant, employee could still have ability to preserve ISO status (if desired) if he or she did, in fact, exercise prior to three months after employment ends.
Cons
- Untimely departures: The pressure to exercise and/or pay taxes often keeps employees at a company until a liquidity event; removing those “golden handcuffs” could prompt departures.
- Administrative burden: Many options will be taxed as NSOs instead of ISOs. Companies will have to remit payroll taxes at exercise, which can be expensive. In addition, tax withholding is required when employees (including former employees) exercise NSOs – this may be difficult to administer.
- Accounting costs: Options with a longer post-termination exercise period have a higher accounting expense.
- Effect on Acquisition: If the company is acquired, it could complicate the transaction significantly if there is a large population of former employee option holders.
- Limited to newer options: Not a solution for older options. Because the tax laws place an overall ten-year term limit on options, eliminating the post-termination exercise period doesn’t make sense for older option grants that are close to their expiration dates.
Clearly, there’s no simple answer to the question of whether companies should follow Pinterest’s lead. But certainly the startup world is taking notice!
At Founders Workbench, we’re following this development closely, and would be happy to talk through any of these issues to help founders arrive at the best solution.