Flashback to 2013. You were so excited when you started your company. You handed out stock options right away to your new employees and shared your expectation that the company would sell in a few years for a big pile of cash. Now it’s 2023 however, and you’re still working away. So are your employees. And because it has been 10 years their stock options are about to expire. What do you do?
Below are a few alternatives to consider:
1. Exercise Options: The employees exercise the expiring stock options prior to their expiration date. The company does nothing to assist employees with the exercise price or taxes.
2. Replace Options with new Options with FMV Exercise Price: The expiring options terminate. As a replacement, the company grants new incentive stock options with an exercise price equal to the fair market value of the company’s common stock on the date of grant. Note that to be an incentive stock option, the recipient must be an employee on the date the new option is granted. The new options can be fully vested on the date of grant. The downside is that any built-in value is lost. You can potentially mitigate some of the loss for them by making the option grants larger than the expired option grants.
3. Replace Options with Change in Control Bonus: The expiring options terminate. As a replacement, the company implements a change in control bonus plan under which optionees are eligible to receive a bonus at the time of a future sale of the company equal to any appreciation in excess of $[X] per share, multiplied by the number of shares subject to their respective expired options. If desired, the change in control bonus plan could impose vesting and or require participants to be employed at the time of a change in control in order to receive the bonus. There’s a general feeling that you shouldn’t mimic the exact economics of the expired options and that it’s best if you wait a few months after expiration of the options to put this in place lest the IRS argue the bonus was a substitute for the options and thus an impermissible extension or deferral.
4. Change in Control Bonus Plus New Options: The expiring options terminate. As a replacement, the company implements a change in control bonus plan under which optionees are eligible to receive a bonus at the time of a future sale of the company up to the current spread per share and grants new options with fair market value strike price to capture future appreciation. As with #3, it’s best to wait a few months to put the transaction bonus in place, and best if it doesn’t mirror lost economics exactly.
5. Stock Grant: The expiring options terminate. As a replacement, the company grants optionees a share of stock for each share subject to their expired options. The company does share withholding to cover the employee’s tax withholding obligation. The shares could be subject to vesting or be fully vested. This alternative requires the company to come cash out of pocket to cover the tax withholding.
6. Loan: The optionees exercise the expiring options prior to their expiration date. The Company loans each optionee the cash necessary to pay any tax. The loan would have a term of 9 years so you could use as its interest rate the midterm applicable federal rate and would accelerate upon termination or a change in control. Interest would be payable quarterly possibly through payroll deductions. The shares acquired pursuant to exercise of the expiring options would be pledged as collateral on the loan, but the loan would be a full-recourse loan (or 50% recourse), meaning employee has to repay with personal funds if stock value is insufficient.
Mike Baker frequently advises with respect to stock options. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.