Extending the Option Exercise Period — A Tactical Guide
Stock options are, and will continue to remain, the primary way startup employees are rewarded for their time and effort. Thus, a debate has sprung up on whether the so-called “golden handcuffs,” the 90-day stock option exercise period, is fair. Several companies have now led the way in making a change, instituting option extension programs, extending the exercise period after you leave a company from 1 year to even 10 years. When Quora and Pinterest decided to change their policies, it was highlighted very publicly in tech news and blog posts. You can read Pinterest’s Medium post on their option extension program here. Others like Asana, Coinbase, Palantir, and Square have since followed suit. As the project manager in charge of the option extension at Square, I want to share some of my findings with a focus on how to implement it.
The arguments for and against making this type of change are better covered elsewhere, but I will note the PROs and CONs we considered at Square before deciding to extend the option exercise period, and discuss how it works from an accounting perspective. I will also share some findings we saw after the implementation, which may help you make the decision of whether or not to take this on at your own company.
The first step is to decide if an option exercise extension is right for your company:
- Frees employees from tying up significant dollars in financial risk
- Allows employees to keep what they have earned — seems like the right thing to do
- Keeps employees here who want to be here — avoids the “vest and rest” problem
- Reduces the number of employees using unapproved investors and loan companies to acquire the funds to exercise
- Positive tool for recruiting — shows commitment to employees and differentiator from other startups
- Consistent with culture and mission of many startups
- The “elephant in the room” — may lead to increased attrition for those already looking to leave
- Tax withholding and reporting for former employees may require putting them back on payroll
- Foreign regulatory issues may be problematic (e.g. security law exemptions may only apply to US employees) — may not be able to offer this fairly across the whole company
- Administrative costs to modify agreements/plans and track modified awards
- Stock based compensation charge — will likely have a one-time charge for all vested options and an increase in stock comp expense over the remaining vesting terms of the awards
- Modify options for all employees, regardless of service
- Modify options only for those with > 1, 2 or 3 years of service
- Choose an alternate approach — eg. net exercise, partner with a lender, or tender offer
After thorough evaluation of our alternatives, we decided the best decision for Square was to extend the exercise period for all employees who had been with the company for a minimum of 2 years. The best way to go about this for us was to modify all the awards at one time (this becomes important later when I describe modifying all at once versus on a rolling basis). Why did we pick 2 years? We felt that after 2 years an employee has made a significant impact at the company, and the 2 year requirement limits some of the attrition risk.
How do you account for this change?
NQs and ISOs
Once you have decided you want to extend your option exercise period, you must first take an inventory of all your options to determine which are Nonqualified stock options (NQs) and which are Incentive stock options (ISOs). This is an important distinction, as ISOs must be converted and will lose their ISO tax status, because by definition ISOs can only have a 90 day exercise period after termination.
In Square’s case, we were lucky that the vast majority of our awards were already NQs, and we decided to not convert any ISOs except for on a one-off basis. If you have ISOs, you have to complete a 29 day conversion period to convert the ISOs into NQs (your lawyers can explain the 29 day conversion period and help you with this process).
Pick an Effective Date
You then need to pick an effective date for the modification and notify all employees of the upcoming change to their exercise period. If all options are already NQs, then you simply need to send out a one-way communication of the change to all employees, since this is a favorable modification for them. ISOs are a little trickier, as you must have each employee sign a conversion document to convert the awards to NQs, and communicate the advantages and disadvantages of doing the conversion (primarily giving up the advantage of not having to pay taxes on the spread immediately upon exercise).
At Square we modified all options on the effective date, regardless of the service period, and modified all awards at once, even if the employee hadn’t hit their two year mark. Employees would still only qualify once they hit two years of service, but their option grant would already be considered modified. This does, however, add to your stock-based compensation charge, as you are modifying all your options at once.
Another option is to modify each individual award on a rolling basis once an employee hits 2 years of service, which is what I believe Pinterest ended up doing. However, I would suggest modifying ALL the options at once and not on a rolling basis, or it becomes a nightmare for stock comp tracking purposes (you will essentially end up calculating the incremental expense each month for each award that now qualifies).
Calculating the Stock-Based Compensation Impact
As with most accounting decisions, you can either take the more aggressive or more conservative position, and this applies to calculating the stock comp impact of an option extension change. As this is changing a key term in the option agreement, it is considered a modification under stock-based comp accounting guidance.
The aggressive argument is that the change will have no impact on stock-based compensation expense. This is assuming you already use the “simplified method” to calculate the expected term of your options. If you are familiar with the Black-Scholes Model and use the simplified method, which can be used if you lack exercise history, then your expected term is probably 6.25 years, or 6.08 years for those “plain vanilla” options with 4 year vesting (1 year cliff, monthly thereafter) and 10 year expiration. Since 6 years is already a long exercise timeline, and likely higher than your actual exercise data would show, you could argue that this would not change your expected term, and therefore not change your stock comp expense. There is an argument that this change in exercise period would preclude the use of the simplified method, as the options can no longer be considered “plain vanilla,” therefore, audit firms prefer your company does some analysis to determine the impact.
The more conservative stance is to look at your data and come up with a fair value before and after the modification on the effective date. This is what we did at Square. This is also where a lot of companies calculate the impact incorrectly. Per the accounting guidance, the modification should be the difference between the fair value before and after the modification, but using the current stock price. We used a firm called Equity Methods to perform the analysis, in which they used a lattice model to measure the probability of different outcomes to come up with an expected stock-based comp charge at the grant level.
Once you have the total stock-based compensation expense you must immediately recognize the amount related to the vested portion of the options. The remainder will be recognized over the individual vesting periods of the remaining options.
New Stock Options Issued After the Effective Date of the Change
Once you know the effective date of the option extension then you should amend all the option agreements going forward with the same terms. For Square, this did not require any change to the Stock Option Plan itself, but thoroughly check your own as all plans are slightly different.
Most companies also consider switching to restricted stock units (RSUs) immediately after the change so that no more options are being granted. If your startup is in the very early stages and just starting to issue stock options, you can save all this trouble by issuing NQ stock option grants with the extended exercise period already in the grant agreement.
So what happened afterwards?
At Square, we noticed no notable increase in attrition due to the change. No increase. This was a terrific outcome as this was arguably the biggest risk of the whole project. At the time we implemented the change to the exercise period, only one-third of the company had been with Square for more than two years, which helped limit the exposure, but as more and more hit their two year vest, there was still no noticeable increase in attrition.
Understanding the logistics of extending the option exercise period will hopefully open the door for other companies to consider making the change. At Square, the change was overwhelmingly positive. As startups are taking longer and longer to go public, this should be the default, not the exception, for employees that worked so hard to grow the company. It’s time to release the golden handcuffs.
UPDATED JULY 2018: Thank you to everyone who continues to read this post as an outline for extending the post termination exercise period at your own companies. I see more and more startups updating their plans to offer extensions. Over the past couple years I have noticed a couple changes I would make to my recommendations. For the accountants out there, I would actually just modify each eligible employee grant once they decide to leave. You will have to do this if you take the Carta approach and keep increasing the exercise period for each year of service. This will be more work each month to do modification accounting for each award, but think it is a bit easier to track than doing it all in one shot. The impact to your stock comp is also less of a one time hit and spread out more over time as employees depart.
Disclaimer: These are my thoughts and observations regarding this topic and not that of Square. The impact of this change has already been reflected in the company’s latest public filings.
Thank you to my lovely wife, for all her edits and feedback on this and other posts.