Understanding Post-Termination Exercise Windows (PTEWs)
It’s estimated that in 2022, startup employees left $1.8B on the table by not exercising their pre-IPO stock options. This staggering number represents foregone potential upside by the employees letting their options expire. Equity that was part of their total comp package and limited cash compensation they received. Leaving equity on the table can happen for several reasons:
- Option holders aren’t aware of their post-termination exercise window and miss the deadline.
- Option holders simply forget to exercise their options given all of the other decisions they need to make after separating from a company.
- It’s too costly for an option holder to exercise their vested options.
Whether through lack of planning or a surprise event, this is an area where an advisor can add immense value.
What is a Post-Termination Exercise window?
A post-termination exercise window (PTEW) is the time an option holder has to exercise their options before they’re forfeited. The type of stock option grant received impacts their PTEW.
Employees can find their expiration details in their stock option agreement. Advisors should request copies of these agreements during data gathering, and with each new grant. Having access to and understanding the full terms the option holder is subject to can make a difference on the advice and actions made by the client.
Incentive Stock Options (ISOs)
Because of the beneficial tax treatment available for ISOs, the IRS stipulates a hard 90-day PTEW rule for these options. ISO holders must exercise any vested but unexercised options within 90 days of termination, or they are forfeited.
Most companies allow the full 90 days for ISO holders to be employee friendly.
Non-Qualified Stock Options (NSOs)
The standard PTEW matches ISOs at 90 days. Companies may allow vested but unexercised options to remain exercisable until the original expiration date.
There’s no IRS mandate like with ISOs because NSOs don’t have the same tax incentive. Many companies have defaulted to this structure as the de facto model unless otherwise stated in the stock option agreement. It can be helpful to create a summary of terms to reference so you don’t have to re-read the documents every time you’re looking for information.
Extended Exercise Windows
Progress has been made on extending the window for stock options to terms that are more favorable for employees. Extensions usually range from 2 to 10 years after separation, depending on the employee's tenure. This provides employees with more flexibility to make exercise decisions over time rather than in an accelerated fashion. This extension raises the chance of an exit before expiration. The ex-employee can sell shares that would have been forfeited.
One important note is that if the company offers an extended exercise window, ISOs automatically convert to NSOs on day 91 (if not sooner based on extension terms). As a result, an employee needs to understand the tradeoffs of exercising as ISOs prior to conversion or letting the options convert to NSOs.
Option 1: Exercise as ISOs
- Pros: It keeps the tax benefits of ISOs. It limits the tax impact at exercise if the 409A increases. And possibly resulting in higher net proceeds at a future sale.
- Cons: A short decision window with immediate cash outlay and investment risk for an uncertain time horizon. Also, there is the added risk of holding common shares of a private company (rather than preferred stock). There is also the risk of incurring AMT on exercise to hold expiring ISOs.
Option 2: Convert to NSOs
- Pros: Possibility of reaching a liquidity opportunity without needing to part with cash. In this scenario, employees can then utilize cashless exercise or sell-to-cover strategies to minimize total out-of-pocket cost on a future sale.
- Cons: Less tax-advantageous (ordinary income and short-term gains) and results in a lower net outcome at a future sale.
If an employee plans to leave the company, it can be smart to exercise some of their vested options as ISOs over time. Then, they can let the rest convert to NSOs to benefit from the extended window. This optimizes the options they want to hold and then creates flexibility for the remaining options.
In rare cases, an employee's stock options may expire during the extended window. This is due to the standard 10-year expiration for unexercised options. For example, if an employee leaves in year 3 of their vesting schedule, and has an extended PTEW of 10 years, they’ll cross the 10-year from grant expiration date before their PTEW expires. If they don’t exercise their options before the first deadline, the options will be forfeited.
PTEW Extension Opportunity and Impact
One planning consideration is the risk of modifying an employee's existing ISOs. This may occur if a company offers to extend the post-termination exercise window. If the PTEW changes, the employer will update the stock option agreement. It will detail the extension and disclosures. The employer will require the employee's written consent to the changes. Sometimes, the extension offer requires immediate conversion of unexercised ISOs to NSOs. Other times, the conversion happens on the 91st day post-termination. This is another example of the ongoing benefit of working with an advisor to help navigate exercise windows.
How to Plan for an Employee’s Post-Termination Exercise Window?
An employee has several decisions to make when leaving a company, whether voluntarily or not. One key decision is to plan for the post-termination exercise window. This helps avoid being forced into a quick decision. It also prevents them from leaving unwanted, unexercised equity on the table.
As an advisor, you should help the employee understand their current financial position and how exercising vested options plays into their other financial goals.
Below are high-level frameworks for addressing three client scenarios.
Best Case Scenario
[You’ve been planning for separation of service with your client and iteratively exercising ISOs to capture their desired exposure. Your client also has an extended exercise window with their vested and unexercised ISOs converting to NSOs on day 91.]
In this scenario, focus on helping your client execute. You’ve helped them build their tax-advantaged position through multiple ISO exercise events and now they need to create a plan for the converted NSOs.
- If your client expects the company to exit during the window, it’s often advantageous for them to wait until liquidity before exercising the NSOs. Remaining upside is limited, and, at liquidity, your client can cashless exercise. This minimizes total out-of-pocket cost and investment risk.
- If the client doesn't expect a near-term exit, help them review their position each year. Then, decide if it makes sense to increase their exposure by exercising some options. It will depend on the spread between the 409A and the exercise price, their expectations for continued appreciation, and their total exposure to the company compared to their total unvested options. An exercise event should be stack ranked with other financial goals.
Mid Case Scenario
[You’ve done some planning for separation of service but your client is sitting on a relatively large position of vested and unexercised ISOs when they leave the company. The company doesn’t offer an extended exercise window and the ISOs expire after 90 days.]
Help your client set a target exposure. Then, determine how to pay the total exercise cost (exercise cost plus tentative AMT). We must know the client's final exposure to company stock, relative to their liquid net worth and upcoming life decisions. To avoid options from expiring, your client may want to take a loan or use other funding strategies.
Worst Case Scenario
[No planning has been done for separation of service. Your client reaches out for advice on day 70 of their 90-day post-termination window looking to exercise their vested and unexercised ISOs.]
Moving with urgency is the key here. Help the client understand the total cost to exercise their options. Then, align on the exercise strategy for their desired exposure. Financing is likely not an option at this point due to turnaround time, so your client will likely need to rely on liquid assets to fund the event. Your client may want to exercise everything to avoid losing the options. But, you should weigh the allocation against their other assets and upcoming life decisions. You want to ensure they're not taking on too much risk. Coaching and managing expectations are the primary responsibilities in this scenario.
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