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Private Company Unicorns: How Expiring Options are Changing Plan Design

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October 03, 2019 | Jennifer Namazi

Private Company Unicorns: How Expiring Options are Changing Plan Design

2019 has been a year of IPOs, with the stock of several unicorns entering the public markets at unprecedented values. In analyzing some of these recent and potential future IPOs, one thing that stands out is that the timeframe from startup company inception to IPO appears to be getting longer. This creates a conundrum for typical private company stock options because of expiration periods inherent in these arrangements. How are employees of private companies reacting to the potential of expiring options, and what are the startups doing about it?
Rideshare company Uber was around for over a decade before becoming publicly traded this year. Online lodging marketplace Airbnb has announced a plan to IPO in 2020 after 11 years of being private. Typical private company compensation arrangements can include packages that are lighter on cash and heavier in equity compensation. The idea here is that as the company grows and increases in value, the stock compensation also increases in value and potentially becomes a lucrative benefit. That’s the ideal and the hope, but in reality the big equity payoff doesn’t always transpire. One increasing reason for this is the longer time frame before an IPO. With options that expire shortly after termination of employment, or at the end of a contractual term, employees of private companies are faced with no liquidity opportunity and a decision to either forfeit their stock grants or exercise them and face a potentially hefty tax bill – one they may not be able to afford to pay. While this scenario of the expiring options has always existed for terminated employees, in the case of long term employees who stay with the company – many historically encountered a liquidity event before being faced with a contractual expiration. As companies are taking longer to have a liquidity event, and with the valuation of some of those startup companies who remain private soaring into unchartered territory, this calls for new considerations in private company stock plan design.

One solution offered by Mary Russell of Stock Option Counsel, P.C. (“Early Expiration of Startup Stock Options – Part 2 – The Full 10 Year Term Solution” – March 28, 2017) is for private companies to offer a full 10 year term for their stock options, with no early expiration (for example, in the cases of termination of employment). According to Russell, some companies only offer this to longer term employees and with caveats in place, such as a minimum employment period for the early expiration to be waived. “The law does not require an early expiration period for stock options. Ten years from date of grant is usually the maximum exercise period, as the legal landscape for stock options makes anything beyond a 10 year exercise period impractical in most cases. The 10 year exercise window (without an early exercise period) enables employees to wait for a liquidity event (IPO or acquisition) to pay their exercise price and the associated taxes. This extended structure is designed to compensate employees in a way that makes sense for them.” 

Other companies who realize that their valuations and or time frame to IPO are more than originally anticipated may choose to modify their current option terms, also extending the early expiration period.   Years before their 2019 IPO, Pinterest took this path, allowing employees with at least two years of tenure to keep their vested stock options for up to seven years after leaving the company. They removed the typical 90-day post-employment option exercise period on most departing employees, which made it easier for its employees to keep their stock options when leaving the company. According to Mary Russell, “This move was in response to their valuation and extreme transfer restrictions that made the early expiration period burdensome for option holders.”

It’s important to consider all aspects of waiving an early exercise period in favor of longer option terms. For example, from a tax perspective an exercise that occurs more than 90 days after termination of employment will change the tax treatment for Incentive Stock Options (ISOs) to that of a Non-Qualified Stock Option (NQSO). NQSO tax treatment aside, I’m guessing most departing employees would rather keep the right to exercise their options for a longer period of time, even if faced with less favorable tax treatment.

Stock plan design might help the stock grants of the future, but what about the grants that are already outstanding – with a ticking clock to expiration and no modification of exercise period in sight? In the case of Airbnb, which is 11 years old and still private, this is a real challenge. Airbnb employees aren’t sitting back wondering what will happen – a recent New York Times Article (“Insider Airbnb Employees Eager for Big Payouts Pushed It to Go Public” – Erin Griffith, September 20, 2019) reported that the employees wrote a letter to company founders in which they strongly advocated for an IPO. According to the NY Times article, “Waiting for the start-up to go public has become a growing source of stress, many said, preventing some from making career changes, starting a family or moving on with their lives.

Questions about going public have risen to the top of an internal message board where employees vote for topics for executives to address every few months, the people said. The discontent has been exacerbated because Airbnb, which has been valued at $31 billion, doled out two tranches of employee equity that are set to start expiring in November 2020 and in mid-2021; those shares will become worthless if the company is not trading publicly by then, they said.”  The Company appears to have listened to their employees, recently announcing that they intend to IPO in 2020 – hopefully before those options expire.
Private company equity grants have long been wrapped in both opportunity and the risks associated with illiquidity. With the startup landscape continuing to evolve, rising valuations of unicorn companies, and increased employee advocacy around expiring options, we are poised to see innovative changes in private company stock plan design.

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