April 1, 2015
 

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  ALERT  
Changing the Status Quo with Extended Option Programs
 

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  Christine A. McCarthy
Partner
Tech Companies Group

1 (650) 614-7634
c[email protected]

Stephen J. Venuto 
Partner
Tech Companies Group

1 (650) 614-7678

svenuto@orrick.com
 

As technology companies find themselves pushing back IPO timelines and staying private for longer periods of time, they continue to aggressively compete for talent, often against public companies like Google and Facebook.  Given the new dynamic in the marketplace, enhancing the effectiveness and competitiveness of equity programs is one area that can help private companies attract and retain talent.  

One approach that captured headlines recently was Pinterest's announcement to offer employees an extended period of time to exercise stock options after employment ends. In a typical private company stock option, employees are given 3 months after employment ends to exercise vested stock options.  Under the new extended option approach, employees will be given a longer period of time (e.g., 7 years) after employment ends to exercise vested stock options.

Why Do This?

  • Employee Morale – Private company employees often feel pressure knowing that they may be put in the difficult position of having to exercise vested stock options within a very short period of time if their employment ends, causing them to have to pay a large amount of money out-of-pocket to cover the exercise price and taxes that arise in connection with the exercise.  The lower the exercise price and the smaller the difference between the fair market value and the exercise price, the less of a concern this is, but it is often still a concern and it is a concern that increases for all option holders (even those with low exercise prices) exponentially as the company performs well, causing the fair market value of the shares to increase.  Removing this pressure is a strong signal to employees that the company cares about their contributions and wants them to realize the value of the equity that vests during their time with the company.

  • Recruiting – As potential new hires compare offers, the offer of a private company stock option without strings on the back end can be a powerful factor in favor of the company offering it.  This can be particularly helpful where a competing offer of equity is made by a public company which the recruit knows can translate into value in the public markets more quickly as the equity award vests (assuming the equity has value).

  • Secondary Sales – In the past few years, we have seen many companies consider and offer to employees the opportunity to sell shares while the company is still private.  There are a number of reasons for offering this benefit, some of which will continue to make these programs attractive for private companies, including companies who offer stock options with extended post-termination exercise periods.  For others, the promise of a stock option with an extended post-termination exercise period will alleviate the pressure to offer employees the opportunity to sell their shares.

  • Option Lending Arrangements – Similar to secondary sale transactions, we expect that stock options with extended post-termination exercise periods will reduce the number of private company employees that seek to borrow money to exercise options (note that, in some cases, employees are engaging in these option lending transactions with the consent of the company, whereas, in other cases, employees are doing this without company consent, whether it is technically required, or not).

What are the Downsides?

  • Retention – Some private companies believe that a short, 3 month post-termination exercise period is an important retention tool as it can make it very hard for an employee to leave the company if they don't have the resources to pay the exercise price and/or taxes that would arise upon exercise of their vested options.  There is certainly some truth to this.  On the other hand, employees who feel compelled to stay only for their already-vested equity may not be the most motivated, best-performing employees and companies should consider whether there are other, maybe better, ways to create retention incentives for employees.

  • Dilution – A longer post-termination exercise period inevitably means more shares will remain subject to options for a longer period of time, which can reduce the pool of shares available for grant to new hires and other employees.  Note, however, that this is not dissimilar to what happens when private companies grant restricted stock units to employees and this doesn't seem to be a major impediment to most companies.

  • Accounting – The accounting expense recognized for these stock options will be higher than a traditional stock option with a 3 month post-termination exercise period.

Any Other Considerations?

  • Outstanding Stock Options – If private companies offer employees the opportunity to amend stock options to provide for an extended post-termination exercise period, the amendment will in most cases cause any incentive stock options to convert to non-statutory stock options immediately upon the effectiveness of the amendment.  Also, private companies should work closely with their legal, tax and accounting advisors to ensure there are no surprises in the amendment process as there are some important issues to address.

  • New Stock Options/Tax Consequences – New stock options with extended post-termination exercise periods can qualify as incentive stock options at grant but will automatically convert to non-statutory stock options 3 months after employment ends.

  • Who Should be Included - Private companies should consider whether it makes sense to offer extended post-termination exercise periods on a broad basis, or on a case by case basis, and whether it should be offered for outstanding stock options or just new stock options.  Note that a case by case basis approach minimizes the downside issues but also minimizes the benefits related to these arrangements.

Please contact Christine McCarthy, Stephen Venuto, or any of the Orrick attorneys you typically work with if you have questions about these types of arrangements.  We have implemented these programs for a number of companies, including Quora and Pinterest, and are well-versed in the nuances that should be considered.