Avoiding the Ten-Year Stock Option Trap (and Other Stock-Option Considerations)

I’ve increasingly spoken to startup employees who find themselves in a difficult trap.  Let’s demonstrate it via an example:

Say you joined a startup in September 2009 as an early employee and immediately received a stock-option grant of 400,000 shares with a strike price of $0.10 when you joined.  The company, while having experienced some ups and downs over the years, has done very well.  At its last 409a valuation, the common stock was valued at $10/share [1].  You feel great; after all, you’re a paper millionaire, with an option worth about $4M [2].

What could possibly be the problem in this seemingly great situation?  Well, sometime in the next 45 days that stock-option is going to vaporize and become worthless.  

More scarily, what needs to happen for that option to become worthless?  Absolutely nothing.  Nobody has to say or do anything.  No notices need to be sent.  Sometime in the next 45 days that option will silently cease to exist [3].  If the company gets acquired two years later at $20/share and you’re expecting an $8M payout you’re going to be rudely surprised to find you get nothing.

The Silent Killer
What happened?  What is this silent killer of stock option value?  Expiration.  The option expired ten years after its grant date.

The vast majority of Silicon Valley stock option plans feature options that expire after ten years.   In this example, your option was granted in September 2009 which means that by October 1, 2019 that option will be expired.  And the really scary part is that nobody needs to tell you it’s about to happen.

While some companies are undoubtedly more proactive than others in both helping employees avoid getting into this situation and warning them as it approaches, in the end, it’s up to you to make sure you don’t get caught in this trap.  Technically, the company doesn’t need to say or do anything.  And – to be clear — because it’s a relatively new phenomenon in Silicon Valley the company may not even have noticed it’s happening and, even if it does, it may remain silent because it doesn’t really have any good remediation options.  It’s a tough situation on both sides because there are no easy wands that anyone can wave to fix this.

If you think you should stop reading here because you’re only at year two of your vesting, don’t.  If you resign (and/or get fired) from your job your stock options will typically expire in just 90 days, so you’ll be facing these same issues — just on a greatly shortened timeframe.

Who Is The Evil Genius Who Set This Up?
None.  There is no evil genius.  It’s simply an unwelcome artifact of Silicon Valley history.  In olden days it took about 4 years for a startup to hit a liquidity event [4] [5].  That’s why stock options vest over 4 years.  It’s also why they expire after 10 years.  All options need to have an expiration date and back in the day, 10 years approximated infinity [6].

As employees, we benefit from the artifact of 4-year-vesting.  However, if we’re not paying attention, we can get crushed by the artifact of 10-year expiration.

What Can I Do About It?
First, this is a tough situation and you may have few or no good options.

Second, I’m not a financial advisor [7]; you’ll need to see your financial and/or tax advisors to figure this out.  In this post, I’ll walk through what I see as some of your options – which will itself demonstrate the problem.

Third, short timeframes are not your friend.  If you see this problem coming I recommend you start thinking hard about it at least 12 months in advance; when you’re down to 30 days left your available choices may be extremely limited.

Here are some of your available options for handling this situation.

1. Exercise the stock-option before it expires. You’ll need to find $40K to pay the company for the exercise, but that’s not the hard part.  Because the fair market value (FMV) of the stock is $10/share you’re going to face a tax bill of somewhere between $1.1M and $1.9M on the exercise, even if you hold the stock (i.e., you don’t sell it) [8].  This is, in fact, the problem statement.

2. Exercise the option before it expires and sell enough to a third-party to pay the tax bill. This means, if you’re selling in the private market (e.g., EquityZen, Sharespost) at the FMV of $10, that you exercise 400K shares and then sell about 150K of them to cover your tax bill [9] [10A].  That leaves you holding 250K shares of stock.  This, however, requires (a) the existence of such a market and/or your ability to independently find a buyer, (b) the stock to be not restricted from you selling it without company approval (or the company granting such approval), and (c) you paying I’d guess $10K or more in legal and/or other transaction fees to make it happen [10].

3. Exercise the option with the support of a specialist fund (e.g,. ESOfund) that cuts rather exotic deals to solve this and related problems [10A]. For example, one of these (typically very boutique) funds might say:  “I’ll give you the cash both for the exercise and to pay your tax bill, if you give me the shares.  When we eventually sell them, I’ll keep 100% of proceeds until I get my money back, 50% until I get 3x my money back, and 25% after that [11].”  These funds are hard to find and the deals can be very hard to understand.  Legal bills can rack up quickly.  And you’ll need to be a major shareholder; no one wants to do a lot of complex work for 2K shares. 

4. Use a company liquidity program, if offered, to avoid getting into the situation.  Some companies periodically offer employees the right to sell shares in order to demonstrate to everyone that liquidity is possible.  Don’t be so busy doing your job that you forget to consider these programs.  While you may think the valuations offered are too low, if there is no secondary market for the stock and/or the company restricts selling the stock after its purchase, you may have no choice but to use such a program.  It’s a far better deal than letting the options expire worthless.

5. Live in Belgium. I believe Belgium has a great law whereby you pay a modest tax at the time you receive a stock option grant and then no tax on either exercise or sale [12].  I’m telling you this not to encourage you to start learning to enjoy moules frites and making immediate plans to move to Brussels (it’s probably too late) — but to remind my international readers that I’m writing from a US point of view and that stock option taxation, in particular, varies a lot from country to country.  If you happen to live in Belgium and the law hasn’t changed, it’s a particularly good place to get stock-options in early-stage startups.   But the main point is to be sure you understand the law of your country before making any plans or decisions when it comes to stock options (or any other tax matter).

6. Avoid the problem in the first place via an early-exercise with section 83b election. Some companies will allow you to exercise your options before they vest by effectively reversing the stock option – you pay the exercise price, the company gives you the shares, and the company retains a right to buy back the shares from you (at the exercise price) which declines by 1/48^th per month over four years.  In addition, if you file a section 83b election within 30 days (and the grant was not in-the-money) then you pay no tax at exercise time and incur tax liability only when you eventually sell the shares, which if it’s more than a year away, results in long-term capital gains tax treatment [13].  Wow, this sounds awesome – and it is.

What’s the downside?  (a) Ideally, you need to do this up-front so it’s not necessarily a good solution if you’re in year three, (b) you need enough money to pay the exercise price which typically works well at early-stage startups (400K shares at $0.01/share = $4K) and a lot less well at later stage ones (100K shares at $5/share = $500K), (c) if the company gets in trouble [14] your common stock could well end up worthless and you won’t get your money back – you are effectively destroying the option-value of your option by exercising it, (d) if you don’t file your section 83b in a timely manner and/or lose your records of having filed it you could end up in a very bad position tax-wise [15].

7. Mitigate the problem via regular exercises along the way (laddered). While I don’t think this is a great strategy, it’s simple to understand, and mixes preserving option value while periodically exercising (and incurring taxes) along the way – so it’s going to be expensive to execute; but nevertheless way less expensive than a forced exercise in year 10.  The two nice things about this strategy are (a) you shouldn’t need company approval to execute it and (b) you can stop along the way and still own some of your options — it only gets very expensive in years 3 and 4.  Here’s a spreadsheet to show it (including some comments not in the image below) which you can download here.

Of course, you may find other strategies, proactive companies may offer programs with other strategies, you might be able to execute a derivative of one of these strategies (e.g., number 3 with a rich uncle), and you can combine the above strategies (e.g., laddering plus early-exercise) as you see and your financial and tax advisors see fit.

I should note that later-stage startups may offer restricted stock units (RSUs) instead of options.  Though some of the same principles can apply (e.g., section 83b elections also relate to RSUs), RSUs work differently than stock options and bring different complexity which is beyond our current scope.

In this post, I’ve alerted you to the ten-year stock option expiration trap and given you a few ideas on how to avoid it.  Moreover, remember that if you resign (or get terminated) that this distant ten-year expiration problem becomes a 90-day problem.  Finally, I’ll point you to my favorite book on this subject (which covers both stock-options and RSUs), Consider Your Options 2019, and which has a nice website as well.

Remember to always talk to your financial and tax advisors before making key decisions about equity-based compensation.

# # #

Notes

[1]  Most private startups get an annual 409a valuation once a year to establish the fair market value (FMV) of their common stock so they can appropriately set the strike price on newly granted stock options, without being accused of granting in-the-money options (as some companies were accused of doing during the dot-com bubble).  409a valuations are always lower than “headline valuations” that companies often announce as part of financing rounds, because headline valuations take the price of a newly issued preferred share and multiply it by the entire share pool (common and preferred).  409a valuations first value the business overall, then subtract any debt, and then subtract the value of “preference stack” in arriving at a value for common stock in aggregate, and then per-share.  Because (a) of how they are calculated, (b) various valuation methodologies produce ranges, and (c) there is a general desire to preserve a low common stock price for as long as possible, 409a valuations not only differ from headline valuations (which are arguably calculated incorrectly) but they tend to produce a low-side estimate for the value of the common.

[2] And maybe a lot more than that because many private, hot-company stocks sometimes trade well above the 409a value in secondary markets.  In fact, in many cases it trades a little or no discount to the price of the last preferred round, and in some cases above it which, unless a lot of time has passed since the last round, strikes me as kind of crazy.

[3] That is, in the 45 days after August 15, 2019 – the day I wrote the post.

[4] For example, Business Objects was founded in 1990 and went public in 1994.

[5] If Silicon Valley were reinvented today, options would probably vest over 12 years, because that’s about how long it takes to get to an IPO.  However, that’s unlikely to happen as the ten years is the maximum duration under law for an ISO option.  This isn’t a VC-change kind of thing; it’s a write your Congressional Representative sort of thing.

[6] The definition of a (call) stock option is the right to buy N shares at price P by date D.  Expiration dates are inherent to options.

[7] See disclaimers in my FAQ and terms of use.

[8] Math is approximate.  On the low side, I’m assuming it’s an ISO option and the tax is all AMT at 28% and you’re in a tax-free state.  On the high side, I’m assuming it’s an NQ option, and a combined marginal rate of 49%.  See your tax professional for your situation.  The main point here:  it can be a huge number.

[9] Bear in mind, per earlier comments, the FMV tends to run on the low side and particularly for red-hot companies, prices in the secondary market can be well above the FMV, e.g., in this case, let’s say $20.  While this will help you on the sale side (you’ll need to sell half as many shares), it could bite you on the tax calculation because you’ll simultaneously be arguing that the stock is worth $10 for tax calculation purposes while actually selling it for $20.  See your tax professional.  Good luck.

[10] I’ve seen and/or heard of cases where companies charge a $5K administrative fee for people selling shares in this manner.  Some companies like it and make it easy.  Some don’t and make it anywhere from hard to impossible.

[10A] There is zero endorsement of any vendor or fund mentioned here.  I provide examples simply to make things concrete in terms of classification.

[11] This is a somewhat flawed representation of such deals, but you get the idea.  The fund effectively becomes your partner in owning the stock.  These can be expensive deals, but for the stock-optionee some value is better than none, which is what they will have once the option expires.

[12] This works particularly well for early-stage startups because I believe you pay a tax of either 9% or 18% of the aggregate value (shares x strike price) of the option at grant time, and the shares are worth next to nothing.  (It works less well if you get a grant of 100K shares valued at $100/share.)

[13] You must, must, must see your tax advisor on this.  You have only 30 days to file an election and if you don’t, you lose the benefits of this approach and can put yourself in a very bad situation.

[14] And trouble doesn’t have to mean bankruptcy.  It simply means any situation where the sale price of the company is less than the sum of debt to be repaid plus the preference stack.  In these situations, the common stock becomes worthless.  Note to the wise:  while it’s often the case, you cannot assume the preference stack is simply the amount VCs have invested in preferred stock.  In some cases, you have multiple liquidation preferences where VCs (or PEs) get 1.5x to 2.0x their investment back before the common gets anything.

[15] See [13].   I won’t go into the details of what happens because it’s complicated, but if you are going to go the section 83b route, you need to file within 30 days and keep very good records that you did.  You remember when people went bankrupt on AMT taxes due to buying-and-holding ISO options in Bubble 1.0?  You could end up rekt in a similar way if you get this wrong.