You have an employee who is leaving. She tells you she doesn’t have the cash to exercise her Company stock option in the first three months post-termination and she realizes if she doesn’t the option will expire. She pleads with you to do something and you are willing because she has been such a good employee.
Can you extend the post-termination exercise period of her option? If so, how?
1. Authority to Amend: The Company equity incentive plan will generally give the board authority to amend options, including to extend exercisability, but it’s worth checking the exact language in the plan. Make sure the requisite formality (e.g., board consent) is used. If the option is an incentive stock option (ISO) you will generally want optionee consent prior to approving the extension, because the amendment can disqualify the option as discussed below.
2. Securities Law: It’s best if the extension of the post-termination exercise period is done on or before the employee’s last day of service. Doing so generally enables the use of securities exemption Rule 701 in case the extension is deemed by the SEC to be the grant of a new option. If you are past that point, you still may be able to amend the option provided it has not yet expired, but you should discuss with an attorney.
3. Section 409A: To prevent running afoul of tax code Section 409A, if her option is in-the-money, in no event should you extend the post-termination exercise period beyond the earlier of the original expiration date of the option and 10 years from the option’s date of grant. Also, prior to approving the extension, you should confirm that the original option was an option to purchase Company common stock, was granted with a fair market value exercise price, and did not otherwise include a deferral feature which would have made it subject to Section 409A.
4. ISO Status: If her option is an ISO, the option will be retested for ISO status on the day of the amendment. Thus, if on such date, the option is in-the-money, or, if the amendment occurs after her employment has terminated, the amendment will immediately convert the ISO into a nonstatutory stock option (NSO). If the option is an NSO when she exercises, there will be tax on the spread on exercise subject to withholding. Note that the option will lose ISO status in any case if not exercised within three months after she ceases to be an employee. Before she agrees to amend the ISO, she should be certain that she does not intend to exercise the option within her original post-termination exercise period. When possible, the Company should have her sign an acknowledgement confirming that she understands the tax impact of the amendment.
5. Tax to Company: If the ISO become NSO, even if the employee exercises in a tax year after the year of termination (i.e., she wasn’t on payroll in the year of exercise), the Company still has a withholding obligation and an obligation to pay its share of employment taxes.
6. Accounting: The amendment to the option will result in modification accounting, with the resulting increase in the option’s “fair value” being recognized as an additional compensation expense. The increased term of the option is an input into the Black Scholes value that affects (increases) the accounting cost of the option. The Company should work with its accountants to determine the accounting cost and the period over which it would be recognized.
Mike Baker frequently advises with respect to stock option extensions. 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.