Post-Termination Options Exercise Solution at eShares
I’m going to start with a caveat. I know it’s poor writing to bury the lede, but I just can’t help myself. This post is on a topic I personally find very interesting, but in the grand scheme of all the things a startup should worry about, this is very low on the list. If you’re an entrepreneur, your time is better spent building your business than reading this post. A lot of Medium post pixels have built spilt on this topic already, and it’s just nowhere near as important as core startup challenges like: building a product people love, finding sustainable customer acquisition channels, aligning sales team goals with company goals, scaling your company culture as headcount grows, mattering in the world, etc… As much as I love talking about the nuances of equity issues and securities law, I can’t help but set its importance in this greater context, lest entrepreneurs start contemplating this subject at length when they have bigger, more important problems to face.
What is the Post-Termination Options Exercise Period?
Post-Termination Options Exercise (PTE) is the concept of how and when stock options are exercised when an employee leaves a company. At least 90% of the companies I have encountered over my decade in VC have a PTE as follows: when an employee leaves a company (voluntary or involuntary, but not for Cause), the employee has 90 days to decide whether to exercise their vested stock options. The reason why >90% of companies have this policy is because they never actively think about this policy, and the company’s securities attorney puts this policy in place by default as a function of setting up the Employee Stock Ownership Plan (ESOP). Securities attorneys use this default because because the IRS disqualifies ISOs 90 days after employment ends, so for an employee to have the flexibility to exercise their stock options beyond 90 days, the company would have to convert the ISO grant to an NSO grant. This is an administrative burden that lawyers assume companies don’t want to deal with and so boilerplate ESOP aligns the PTE with this 90 day window set by the IRS.
Why Does PTE Matter?
The default PTE unfairly benefits employees that are wealthy and have liquid assets. If you can afford to exercise your stock options, then you have more freedom to leave your job when you desire and you’re more likely to exercise your options, which I hope is generally a positive outcome and good decision.
Most employees think they are earning equity as a part of their compensation for working full-time at their company. Employees that leave who cannot afford to exercise their vested options frequently feel like they are being stripped of equity compensation they earned retroactively. This is not technically the agreement being the company and the employee; the exact language of PTE treatment as written is the actual truth. But I am very sympathetic to this point of view, and emotionally I side with how employees feel in this situation as opposed to the language of the PTE section of the legal agreement.
My Best Experience Developing a PTE Policy
I serve on ten boards on behalf of Spark. I’ve had a conversation about PTE at some time over the past two years with almost all these boards. The best PTE conversation I ever had was with the eShares board. The management team there was incredibly thoughtful on the subject. The conversation on PTE was led by Mike Wu (a recovering securities lawyer with Cooley, now for 3 years a key member of eShares leadership). Mike solicited advice from securities counsel, did his own independent research, and summarized his findings in a thorough presentation on the subject of PTE to the board. The presentation covered what most companies do (the default I explained above), what a handful of companies have changed to (such as Pinterest, Quora, Amplitude, Triplebyte, etc…), the risks/downsides to a company extending the options exercise period, and the paths available to eShares going forward, including a recommendation from the management team. After the presentation, everyone on the board was well-educated on the subject, and we had a great conversation. The board accepted the company’s recommendation, and, fast-forward a few months later, Henry Ward, eShares co-founder and CEO, released a blog post recently that summarizes eShares’s new PTE policy.
eShares’s new policy is best read on their blog post, so please go read it. Summarizing here would take longer than eShares own blog post, especially given their great information visualization work in their post. It’s a complicated subject, and the blog post is quite concise.
How I Am Handling PTE Conversations
eShares new PTE policy is the fairest solution I have seen to this problem. Some companies are extending the exercise period for all employees to 7 years. I think equity compensation should be used to encourage long-term alignment of incentives between the company and employees, and I don’t feel that an employee who works at a startup for 1 year should get the same PTE treatment as an employee who works for 5 years. eShares PTE policy creates a linear sliding scale in how employees leaving between 1 to 5 years are treated, and that feels to me quite right.
I mentioned earlier in this post that I’ve had PTE conversations with nearly all of the ten boards I serve on. I am not prescriptive in these conversations on these boards. Instead, I present a couple choices, explain their tradeoffs (thanks to the excellent education I received from eShares), and then just listen. I ultimately leave the decision of PTE policy up to the company’s management team. I think this is a personal decision for each CEO that reflects company values and how they want to align employees incentives with the company’s goals.
When I describe the various choices available to a CEO to modify the company’s PTE approach, I usually sketch the choices out as follows:
We (this “We” is me talking to the company management together collectively) likely have the current PTE setup: employees have 90 days to exercise their stock options PTE, after which point their ISOs expire and the options are returned to the ESOP if left unexercised. So Choice #1 is to leave this policy in place and do nothing. This is the easiest thing to do. The company benefits from this approach: A) avoid the legal costs of changing PTE and existing employee equity agreements B) avoid the legal costs of doing ISO-to-NSO conversions for employees on day 90 post-termination of work (the sum of legal costs in (A) and (B) are very material) C) incur less dilution from the ESOP because some options will likely return to the ESOP in the future which can be reallocated to other future employees D) avoid the tax withholding and payroll taxes required on the delta between an NSO exercise price and the current 409a price of Common shares. This choice is the path of least resistance, but it is the least employee-friendly choice. And, clearly we are having this conversation today because you feel there is a fairness issue that is worth addressing.
Choice #2 is the opposite extreme, which has be executed by companies like Pinterest and Quora, which is do extend the exercise period for all ex-employees PTE to 7 years for everyone. All those benefits to the company mentioned in Choice #1 now become hurdles. Employees will have the freedom to leave and take all their vested equity with them for a very favorable time horizon. There will no longer be an inequity that unfairly benefits wealthy employees.
Choice #2.1 is the same as Choice #2, but instead of 7 years, the number is X. X is nearly always a number smaller than 7. It’s a compromise option between Choice #1 and Choice #2.
Choice #3 is to give the management team the discretion of extending PTE for only some employees in certain cases. Sometimes when an employee leaves, the relationship is acrimonious. Sometimes the ex-employee can say things that causes the company harm in the future, post-employment. The management team might not feel great knowing they are going to work everyday making these acrimonious-ex-employees’ stock options more valuable. Granting PTE selectively is a very sensitive issue, and rightfully controversial. Generally speaking, I don’t like the idea of treating two employees in the same situation unequally, but this Choice #3 makes PTE a tool in a management team’s tool belt to be used at their discretion.
Choice #4 is to do what eShares does. I now gratefully can point management teams to eShares’s blog post describing their vesting-based approach to PTE. Prior to this blog post being written, I would just describe in words a rough outline of their approach. It is my favorite choice, but as I said earlier in this post, I am not prescriptive in these conversations, despite this being my favorite. It is my favorite choice because it rewards employees who commit for a longer period of time with a more flexible PTE timeline, and this reward grows linearly, without hurdles that force arbitrary decision points.
A surprising anecdote from Mike Wu’s presentation to the eShares board is that most companies in the startup ecosystem are having this exact same PTE conversation, but very few companies are actually changing policy. A lot of companies are having this conversation and then choosing Choice #1. There is a great summary of why companies are ultimately not changing policy in this Quora answer by Quora employee Steven Trieu. But I think the biggest reason is the difficulty of inertia. If picking a new PTE policy were as simple as clicking a button, I suspect many more startups would adopt a more employee-friendly PTE policy. That’s exactly what eShares is working on, and it’s one of many reasons why powering your company’s capitalization with software instead of paper is just common sense. You can chat with eShares to learn more.
I started with a caveat, and I’ll end with a caveat, for symmetry’s sake, and also a little bit of CYA. I’m not a lawyer. I didn’t even stay at a Holiday Inn Express last night. Don’t interpret any of this as legal advice. If you are a lawyers, and you read this far down, and you think I’ve misrepresented important legal issues or just totally F-ed up some part of this post, please let me know. I’d love to correct it. And final caveat, this post is not Spark Capital’s opinion, it’s strictly my own.