Holders of stock options must exercise their vested options within a certain predefined time period after they cease providing services to the company. This time period is known as the “post-termination exercise period” (PTEP).
What is the standard PTEP?
The standard PTEP is three months. This means that after option holders leave the company, they have three months to exercise their vested options before the options automatically terminate.
Why not offer a longer PTEP?
In 2016 the venture capital firm Andreessen Horowitz recommended a longer PTEP for tech startup employees, which generated a lot of buzz. In the wake of that article, some startups offered longer PTEPs for vested stock options (in some cases, as long as ten years) on the theory that the option holder had earned the vested options and should have the opportunity to receive the value from their work, even if the startup takes a long time to complete a liquidity transaction. These startups attempted to minimize the likelihood that option holders wouldn’t realize any value from stock options if they couldn’t afford to exercise them within three months after leaving the company.
However, since then long PTEPs haven’t really taken hold in the market, for several reasons:
Disincentives to long-term service. With a longer PTEP, short-term employees could still potentially realize some value from their vested options without having to exercise them soon after departing. This could treat short-time employees similarly to employees who have been loyal to the company for a longer time and could reduce the disincentives for an employee to quit. Also, longer PTEPs could effectively shift some of the proceeds of a liquidity event from longer-term employees to shorter-term employees. These unintended consequences conflict with the point of stock option vesting generally, which is designed to incentivize long-term service.
More dilution. Longer PTEPs increase dilution and are likely to be viewed unfavorably by investors. This occurs because options with longer PTEPs remain outstanding for a long time and are not recycled back into the pool when employees leave the company. To make grants to new employees, startups then need to add more shares to the pool, resulting in more dilution to founders, existing option holders, and investors.
Tax issues. The standard three-month PTEP is built into the rules governing incentive stock options (ISOs). Options exercised more than three months after termination of service cease to be treated as ISOs, and if a longer PTEP is offered at the time of grant, the options aren’t eligible for ISO treatment.
What if I choose to offer a longer PTEP?
The decision to offer a longer PTEP is a policy decision based on the company’s philosophy with respect to retaining and rewarding employees and other service providers. There is no one correct answer, but any decision to offer a longer PTEP should be made at the board level after weighing the pros and cons, including the possible consequences (intended or not) of such a policy.
If you do choose to offer a longer PTEP, you should consider whether it is best to offer it across the board or on a selective basis, either as part of an employment offer to a highly desirable candidate or at the time of an employee’s termination.
Also, there are several considerations when drafting the language for a longer PTEP that you should discuss with your counsel.
For more on stock option vesting, see these prior Founder Tips: Vesting Basics – What is vesting? and Vesting Basics – What are typical vesting schemes?
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