3 Ways Startup Employees Can Fix What’s Broken About Stock Options

By Vieje Piauwasdy, Senior Director of Equity Strategy. As an equity compensation and taxation expert, he guides startup employees through the complexities of private company equity to ensure that no money is left on the table. Prior to joining Secfi, Vieje spent years at PwC, where he specialized in tax reporting and strategy for hedge funds, private equity funds, and asset managers. This article is not investment advice.

You don’t have to look hard to find stock options horror stories in the startup community (Blind is full of them).

The marketing manager was surprised to find he had to purchase his stock options when he quit his job at a fast-rising unicorn (with only 90 days to do it) and lost them. 

The engineer who paid hundreds of thousands of dollars to exercise her stock options, only to lose it all when the startup failed the following year. 

The operations director who feels trapped by golden handcuffs at her job, because the only way she can afford her stock options is to perform a cashless exercise once the company goes public.

The industry’s increasing trend toward mega-sized rounds of unicorn funding has only exacerbated these problems, as the cost to exercise stock options skyrockets, and exit horizons get extended years into the future.

The good news is that there are three immediate cultural changes that startup employees can lobby their startup’s leadership for that can go a long way toward fixing these problems:

• Advocate for better stock options education at a company level
• Extend the post-termination exercise window out to 10 years
• Offer a way to buy stock options that minimize financial risk

Let’s take a closer look at each of these solutions.

Advocating for better stock options education at a company level

Stock options represent a crucial part of any startup employee’s compensation package, but they’re rarely talked about during onboarding, and few companies provide ongoing education about stock options during major events, such as new rounds of venture capital. Currently, 57% of startups are not doing enough to educate their employees about their stock options.

Instead, it falls on individual employees to educate themselves on the process of exercising and the potential tax implications that come with it. For employees who have only ever earned restricted stock units (RSUs) at previous companies, they can be surprised to learn that they could have to pay their tens — or even hundreds — of thousands of dollars if they want to own their stock options.

Stock options are integral to startup compensation packages, but many employees are unaware they have to pay for them, let alone that they can get more expensive over time and trigger large tax bills. That might be why 87% of startup employees say they value being educated about their equity, which is more than the 78% of employees who said they value the stock options themselves.

In an industry where benefits and perks have become the fodder for satire (thanks HBO), equity education should be a must-have at startups to arm employees with the knowledge they need to make informed decisions about their equity.

Extending the post-termination exercise window out to 10 years

When you leave your job, you might find that you have just 90 days to come up with the cash necessary to exercise all of your vested stock options. If you don’t, you could lose them forever.

A handful of forward-thinking companies have voluntarily extended their post-termination stock options exercise windows to as much as 10 years. This employee-friendly policy gives early employees the ability to lower their financial risk, while still sharing in some of the upsides that they helped create by helping the startup when it was still tiny.

Here’s why that’s important. 

No matter the size of a startup, employees are asked to take on financial risks around their stock options. Early employees are able to exercise their stock options for relatively small amounts, but they’re asked to do so when the risk of the startup failing is at its highest.

As startups now routinely stay private for five years or more, early employees exercise their stock options with no idea when (or if) they might see a return on their investment.

When a startup fails, or experiences a disappointing exit, common shareholders (i.e. the employees who exercised their stock options early) usually lose their investment, while preferred shareholders — the startup’s founders and investors — jump to the front of the line to divvy up any money that’s left.

Fast-forward to several years later in a startup’s life, when it’s raised several hundred million dollars in venture capital and the chance of success is high. Here, the cost to exercise stock options skyrockets. 

Employees who leave their startup before an exit event routinely face unmanageably large tax bills. In 2021, the average cost to exercise stock options was $543,254 — an amount that few people can comfortably afford.

By voluntarily extending a company’s post-termination stock option exercise window, employees who leave a startup early can sit back to wait and see if the company gains more traction and the risk of failure is no longer imminent. In some cases, the company might experience an exit event inside of that new, longer post-termination exercise window, which may allow early employees to perform cashless exercises on their stock options.

Today’s industry-standard, 90-day window is unnecessarily short for employees, who should lobby for it to be extended.

Offer a way to buy stock options that minimize financial risk

There are some good tax reasons to exercise your employee stock options before an IPO. For one, exercising now starts the clock on long-term capital gains, and allows employees to minimize their upfront tax liability, before the value of their shares jumps with additional rounds of funding.

However, employees who want to exercise their stock options now face tough choices around how to afford their cost — typically choosing to use their own money, take out personal loans, or list their shares on secondary markets.

If a startup fails, you can lose your own investment, or worse, find yourself on the hook to repay a traditional loan with interest. Secondary markets are typically subject to board approval because it’s a transfer of ownership to a third party, and they can take some time to complete. If you’re in a 90-day window, time is not on your side. While a secondary sale could give you much-needed cash today, you’d also lose out on potential upside since you are selling your shares to someone else.

With non-recourse financing, the financing company assumes the downside risk in the transaction — if the startup fails, or experiences a disappointing exit, the employee typically doesn’t owe the financing company anything. Plus, you retain full ownership of your exercised shares — there’s no transfer of ownership. 

Startup employees should push for these three policy changes, to even the playing field around stock options. These changes will require buy-in from startup founders who want employees to share in the startup’s success, without taking on unnecessary risk.