March 1, 2016
Considerations for Changing Post-Termination Exercise Periods
Posted by Scott Schwartz
Business Insider recently shared another example of stock markets influencing tech companies (Yahoo is Letting Employees Cash Out Stock Options Sooner to Stop the Brain Drain). We’ve started seeing companies adopting non-standard vesting schedules to entice key employees to stay with the company. Additionally, companies have begun to extend post-termination exercise periods and sometimes even eliminating the typical one-year cliff to allow employees to cash out some stock options after just one month.
Armanino’s Equity team has seen a growing number of companies following the Pinterest trend by extending the post-termination exercise period. However, like any employee benefit, and especially when it comes to complexity in equity compensation, a company should always consider the benefits and potential ramifications. The extended time to exercise may preclude the company from utilizing Black-Scholes to value its options for accounting purposes. It may require a company to use a more complex valuation like Lattice or Monte Carlo. At a minimum, for those clients who were using the “Simplified Method” to calculate expected term—forget it! These types of awards are no longer “Plain Vanilla” and violate one of the key principles of the simplified method.
The other reality to consider is the potential impact on future dilution. When options are exercised at termination (or not exercised) the common shares outstanding are known. With such a large number of options being held outstanding by ex-employees, it may be much more difficult to manage the cap table. Future investors (private or public) may not prefer that potential dilution. Additionally, allowing options to remain outstanding for longer will also impact the replenishment of your option pool.
From a tax perspective, Incentive Stock Options (ISOs) become taxed as non-qualified options after 90 days post-termination. (The difference there being tax at exercise versus sale.) A company is required to pay (usually collecting from the person who exercised) the tax obligation of the difference between the Market Price at exercise and the exercise price. Even if the participant who exercised has not been an employee for years, under IRS regulations “withholding and reporting is required on any payment of wages made to an employee even if at the time paid, the employer-employee relationship no longer exists.” This means not only is the company required to withhold and pay the taxes on the exercise, but the company would also need to report W-2 income for that exercise.
While accounting and compliance shouldn’t necessarily drive key business decisions, they can’t be ignored; it’s important for a company to consider all of the implications before modifying its plan. If you are going to change post-termination provisions or vesting schedules, don’t modify historical grants because it can be even more challenging. We recommend that if you want to make a change that you only do so on a prospective basis. If you are considering such an adjustment to your plan or grants, we’d be happy to discuss you options to determine the best course of action for your company.
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Scott is a partner in our CFO Advisory Services practice who helps companies handle a wide array of business valuation needs, equity compensation challenges and technical accounting issues. He provides equity consulting and stock option administration services, as well as company transactions, award modifications and initial public offerings.