Bringing optionality to options: Extending the exercise window

This is a continuation in our series on how we view compensation here at XMTP. You can read our previous post detailing how we’re getting rid of the standard vesting cliff as part of our stock options for employees. Now…onto our thoughts on extended exercising of options…

The vast majority of startups tend to issue stock options to its employees as part of their compensation package. Its purpose is to give employees skin in the game, and a way to share in the upside of the company should it reach an IPO, exit, or similar event. However, many employees that depart never get to reap the rewards of those options because for various reasons they were unable to exercise and purchase their stock.

We think it’s incredibly unfair when some former employees don’t get to win when the company wins, especially when the reasons are either technicalities or stale, outdated standards. Let’s have a look at what the current situation is like for most people:

People can’t exercise their options

According to an analysis done by Carta showed some shocking statistics on the rate of exercise. They found that when the stock had reached an 8x fair market value to the exercise price rate, 40% of people still didn’t exercise the options. If the cost to exercise increased over $125,000 they found that over 70% of people didn’t exercise.

While the specifics as to why they didn’t exercise could be wide-ranging, one very common reason is not enough capital to exercise. I’ve personally been in that situation before and it feels really crappy to leave potential money on the table. This happens most often when the expiration date of the options occurs before an opportunity to sell the stock that’s acquired, therefore leaving folks without enough money to do it.

Most exercise windows are all of 30-90 days, meaning that when an employee leaves the company they have less than 3 months to gather up the cash needed to buy the stock. Worse yet, they can be on the hook for some immediate tax consequences depending on the type of stock. Why in the world would companies only give 90 days to exercise you ask? It’s all part of the way that the IRS handles options, specifically incentive stock options (ISOs).

Incentive Stock Options (ISOs) vs. Non-qualified Stock Options (NSOs)

This is getting in the weeds a bit, but stock options come in one of two forms: an ISO or an NSO. ISOs carry special tax treatment, which can be beneficial for the exiting employee, but sets a hard limit of 90 days to exercise. Following termination, NSOs can have a longer exercise window as determined by the company, but they carry an immediate tax consequence for the employee. Should the employee exercise an NSO they are taxed on the difference between their strike price (what price the option was when it was granted) and the current fair market value.

The tax burden someone may experience after exercising an NSO can be crippling. Even though there may not have been a sale of the stock yet (a liquidity event), the employee still has to pay taxes for the delta on the increase in value as income for that tax year. It’s crazy, but that’s how it is.

So given all of the above, we wanted to find a better way to help ensure that our team members are able to share in any future upside we might be able to achieve together as a company.

Opening up the exercise window

When someone joins our team, we’ll initially issue the stock as an incentive stock option. This gives the employee the most tax advantageous setup possible for the moment. Then, should the employee be leaving on reasonable terms (more on that below), we’ll be happy to convert their ISOs to NSOs and extend their exercise window, matching the length of time they’ve been at the company.

To dig in a bit further into the specifics, here’s the excerpt about extended exercise directly from our handbook:

The standard operating practice in startups is to offer a 90-day window to exercise stock once a person has departed a company. We recognize that this could create an untimely or untenable burden, which may lead people to be unable to exercise their options and miss out on any future upside in the company. For those that are leaving the company on reasonable terms we believe there's a better way to do this.

For those that qualify, XMTP, Inc. offers an exercise period equal to the number of months that their stock had vested at the company. So in this example if you've stayed for two years, you'd have two years from the date of departure to exercise your options.

To be clear on what constitutes leaving on "reasonable terms," it's largely based on our "How to Quit" guidelines, with a couple additions:

1) Have early conversations with whomever you report to, letting them know about how you're feeling about things, and if you're inclined to consider leaving. If you're uncomfortable in having that discussion with them, you can communicate that to People Ops.

2) If you do intend to leave, communicate that in a live discussion with whomever you report to, or someone in People Ops. This should take place no less than 3 weeks prior to your intended departure.

3) Ensure that you're leaving with a clear transition plan in place so that process can meaningfully continue for the things you have been working on.

Above all else it comes down to communication. If you're communicating sufficiently with the necessary individuals and teams, and you're not leaving for a competitor, you'd qualify for extended exercise.

Note: Anyone terminated for-cause would not be eligible for extended exercise.

Join us

At XMTP, Inc. we’re committed to building a company that’s deeply aligned with its employees. If you have some feedback or just want to chat, hit us up on Twitter or our contact page… or say hi to us personally on Twitter: Matt & Shane Mac

Be sure to check out our career opportunities here: careers.xmtp.com.

Photo by Vladislav Babienko on Unsplash