One Simple Thing Startups Can Do To Make Employee Options More Valuable

The grants you receive when you join a startup are a core part of your compensation, just like your salary. You include the potential value of those grants in your calculation as to whether to join or stay at your company, right? 

But the difference between salary and options is significant. You put your salary in your pocket every couple of weeks. Options are only valuable if your company is successfully sold– that’s a big “if”. Especially in this volatile climate for startups, there is no certainty that your company sells for a number that yields a nice payout.

Even if it does, when it comes to employee options, there is a huge catch. Like a raffle, you must be present to win. That means you must still be at the company to cash in on your options. Or, if you choose to leave, you have to exercise your options and buy the company’s stock and become a shareholder. In most startups, the exercise window is only 90 days after you leave. Fail to exercise within 90 days and your options are forfeited. 

I’m not talking here about your unvested options. Those are immediately forfeited when you leave. I’m talking about the vested options, the ones you earned for working at the company over the years. As you vest, you earn the right to buy the company’s stock and participate in the company’s upside. Sounds pretty good, right? 

But what happens when you leave? You face a dilemma. With no certainty of an attractive payout, most departing employees reasonably choose to keep their hard-earned cash and don’t exercise their options. There is significant risk in investing in a private company with an uncertain future and no public market to cash out the shares you acquire by exercising. Besides, if you exercise, you also have a significant tax bill with no cash inflow to cover it. 

If you’re like most people, you take the path of least resistance. So 90 days after leaving the company, those unexercised options go poof!  And your upside–the upside you earned over years of going to work–goes with it. This is not an isolated phenomenon. 

Nearly every startup that issues options uses the same formula. Vest over four years. Exercise or lose your options within 90 days of leaving. As a result, many employees lose the options they worked for through the clawback of unvested and unexercised options. Imagine if, after you left your company, the company had the right to reclaim a large chunk of your past salary. You’d be pretty upset. But In a way, isn’t that what’s happening with the vested options you forfeit? 

The 90-Day Option Exercise Window is Unreasonable

The problems with the 90-day exercise window are two-fold. First, it is too short. It puts too much risk on the employee. There is little possibility that anything significant will happen in those 90 days to provide you with certainty that exercising your options is a good investment. If your company receives a buyout offer it might be a no-brainer. But even if it did, management would keep that a secret, and you’d probably never know unless the deal closes.

Second, it relies on employees who are leaving to place a bet at a time when they are least inclined to do so. If you’re leaving your company because you see a better opportunity, why invest cash in a company about which you are uncertain? And if you’re leaving because you were laid off or terminated, can you afford to (and would you want to) shell out cash to buy stock in a company that just told you they don’t want you around? Fat chance!

The Solution

There is no guarantee if you hold options that you will get a payout. But if you earn options you should at least have the opportunity to see what happens before you lose them. There is a simple solution– companies should extend the exercise window after an employee leaves.

Executives who join startups sometimes negotiate for an extended exercise period, upfront or when they depart. If they leave on good terms, the company’s board may be inclined to play ball. But why should that privilege be extended only to the top brass?

Extending the exercise window is not only fairer to employees but can provide companies with a great retention tool. The concept is simple. Restructure the “gun to the head” 90-day exercise window, and employees will be more motivated as they see a likelier path to sharing in the company’s success. I recently heard about a company that provides employees with four years of tenure a multi-year exercise window post-departure. I was impressed by the thinking associated with that policy. 

There are obviously different ways to structure the exercise extension. But one approach may be to tie the exercise window directly to the employee’s tenure–stay a year, and you get a year to exercise your vested options. Stay two years, and you get two years, etc. Since options expire after ten years, the formula is capped at five years–five years tenure plus five years exercise window.

Short-sighted investors may like the option clawback feature to recapture unexercised options–it’s like a stock buyback where the company doesn’t have to spend any cash. But I believe visionary companies would do well to consider an extended exercise window on employee options. They can use it as a recruiting tool or tout it to motivate existing employees. 

If employees vest their options through their hard work, why shouldn’t they have a fair chance to see if those options are ultimately worth anything? Companies that extend the exercise window will have more committed and motivated teams, and the collective value to their companies should far exceed the small amount of upside their investors give up.