Options done right

In a legal and business career that spans more years than I care to admit, I’ve worn many hats (some of them at the same time): entrepreneur, company founder, early employee, investor, and attorney. Understanding an issue from multiple directions means that, perhaps unusually among lawyers, we typically counsel our startup company clients to implement legal terms that, while not representing the most aggressive possible stance, represent a fair one – one that we feel will ultimately result in the best outcome for all parties, including our client.

The Problem

Take, for example, the exercisability of stock options by employees upon their separation from employment, governed by company incentive plans and award agreements. Most such documents require that upon an employee’s departure, he or she must exercise vested options within 90 days, or else lose them. Even though the employee no doubt wishes to depart with all of the equity he or she has presumably earned, as a practical matter (as we have noted in a previous post), the vast majority of ordinary employees lack the means to come up with the cash required to pay the exercise price of the options, not to mention in some instances a sizable tax bill to boot.

Some argue these “use ‘em or lose ‘em” exercise terms are unfair, and they have a compelling case. Options an employee has earned can end up being forfeited, and if the company later has a successful sale or IPO, the employee misses out on substantial gains. Employees who do not scrutinize these terms up front are likely to be sorely disappointed at the end.

Moreover, these terms are inconsistent with the way many of these same companies treat stock grants to employees in the early days of the company. (Newly formed companies are able to grant stock outright, but further out on the growth curve, options predominate.) In most instances, a separating employee can hold vested stock all the way to an ultimate exit event.

The Solution

There is a straightforward solution, which goodcounsel has for some years now recommended to its clients: make vested options exercisable for a set number of years after grant, regardless of whether the recipient remains in service to the company. Apparently, we were not alone in our thinking. Quora switched to just such a system in 2014, and some well known Silicon Valley startups such as Asana (founded by Facebook co-founder Dustin Moskovitz) and Pinterest have followed suit. (There’s an informative discussion about this on Quora.)

Problem solved!

So why doesn’t everyone do this?

I’ve heard some reasons, which generally I don’t find that compelling. Does having more optionholders over time involve some additional administrative burden? Marginally; it is some additional lines on the cap table. Does it mean less equity is available from the current equity pool for future employees? Of course. But that begs the question: if additional incentive equity is required, why should the subset of departing employees have to forfeit the equity they’ve earned to supply it? The company can always issue more, which dilutes all stockholders just a little bit, rather than confiscating it from departing employees.

In the end, we believe that our recommended approach is not only more equitable to the employee, but in most instances is in the interests of the company, too, for reasons ranging from building reputational capital in your startup community (i.e., being known as a fair, employee-friendly startup is vitally important to compete for talent) to maintaining a creative and motivated workforce. (Pinterest’s take on this is here.)

Of course, every company has its own interests and unique circumstances to consider. If a company chooses, with open eyes, to require departing employees to promptly use or lose their options, that’s its prerogative (and of course, goodcounsel would represent its position zealously), and better still if employees understand what the option documents say too. (I don’t personally believe there’s long-term advantage to companies from employees misunderstanding their benefits.) The problem we see is that this language is buried in excessively long, endlessly rehashed equity plan documents, and clients (excepting of course goodcounsel clients) do not always understand the real-world ramifications for themselves and their employees. Companies might be as surprised as their employees to learn what their plans say.

At goodcounsel, we don’t believe in always doing things the same old way. Our clients are thoughtful and creative, and we have to be too.

Categorised as: Capital Structure, Startup Stuff