Jay Parkhill March 7th, 2008

I get this question a lot from clients. It used to be a very simple situation- companies hired employees and granted them stock options as incentive for expected work. If the employees quit, it stood to reason that they were no longer providing valuable services.

Therefore, essential stock option terms included (i) vesting of the option based on time spent as an employee, and (ii) outright cancellation of the option 90   This post is about part (ii) of that formulation.

IRS rules codify both of these rules. Incentive stock options (the tax-advantaged kind) are only available to W-2 employees and can not be exercised more than 90 days after termination. The other kind, non-statutory options, are not subject to that restriction, but many or most stock option plans say that *all* options expire 90 days after termination of service regardless.

Most companies I work with hire a core group of personnel, but outsource substantial amounts of work (and value creation) to non-employee contractors. The model above has substantial flaws in that case, because it is hard to tell when a contractor “terminates” service.

So are the stock option plan terms wrong? ISOs are locked up by IRS statute, but should NSOs be more flexible to allow termination for more than 90 days after termination?

My answer is generally no, but occasionally yes. Stock options take a lot of attention to administer. They can easily end up “leaking” equity out to people who no longer provide value to a company. For this reason, I encourage my clients to adopt a policy of expiring options after termination. The 90 day period makes it easier to manage ISOs and NSOs without excessive brainpower.

At the same time, there are occasions when a company may wish to allow contributors to exercise options after termination. A private company with a number of long-term contributors (employee or contractor) and a relatively high stock price might choose to let these people retain their options after termination as a way of saying “Thanks for your efforts. We’d prefer that you exercise and get the stock itself, but the exercise price makes that prohibitive, so we’ll let you hold the options until we have a liquidity event”. These situations are few and far between.

The remaining question is how to handle contractors who may make valuable contributions, but work irregularly for the business. An investment banker in this situation might get warrants, which are identical to stock options except that they expire at a prescribed date rather than based on service.

My advice in this situation is to keep warrants for the bankers (the finance types are happier seeing that) and use stock options for contributors to the business itself. This is where an NSO that is exercisable regardless of the holder’s term of service to the business can make sense.  Cases like this in which people provide *really* valuable services that merit long-term options are few and far between, but they do come up.

Tags: employment, stock options

• Comments Off