Extending Post-Termination Option Exercise Periods: What You Should Know

Stock options issued by US-based startups typically allow the optionee to exercise the option within three months (or shorter) after a termination of employment not involving death or disability. Companies often ask us about extending this post-termination exercise period, whether for a particular optionee or for optionees more broadly. This can turn out to be an unexpectedly complex and difficult question for startups, involving legal, business and personal factors.

This article explains why the three-month window is so common and discusses some of the points that companies should consider when thinking about changing the post-termination exercise period.

Why the three-month exercise window?

Most US private companies prefer to grant options that are eligible for treatment as “incentive stock options” (ISOs) under the US Internal Revenue Code. Under the right conditions, ISOs can result in tax advantages for the optionee. To be eligible for ISO treatment, options generally cannot be exercised more than three months after termination of employment. Because of this requirement, a post-termination exercise period of three months (or less) is often baked into a company’s standard stock option agreements. The same considerations also apply to non-US companies granting options to US taxpayers. Note that options may have different exercise periods in some circumstances – for example, the time period for an optionee’s heirs to exercise following the death of an optionee.

For a more detailed discussion of ISOs, including the additional requirements that options must satisfy to be eligible for ISO treatment, see this Cooley GO article.

Why the length of the post-termination option exercise period matters

The three-month exercise window means that, if an optionee is terminated, they will generally have three months in which to exercise the vested portion of their option, by paying their exercise price in cash to the company. If the optionee does not exercise within that window, the optionee loses all rights to the option and the underlying shares, which then become available for issuance to other service providers under the company’s option plan.

Exercising the option may be expensive, especially if the option was granted after the company matured and the exercise price per share is significant. An optionee may not be able to afford to exercise or may need to get a loan or make other arrangements to fund the exercise, which itself can involve additional complexity and risk. Further, the optionee will be paying this exercise price for illiquid private company stock, whose ultimate value is often far from certain. This dynamic – requiring a quick and expensive decision – may be perceived as unfair to the optionee, who may have worked for years to earn their vested options. As a result, a typical optionee may generally prefer to have longer than three months to exercise their option.

Companies (including other stock and option holders), on the other hand, generally don’t want unexercised options to remain outstanding any longer than is required. Unexercised options that are “in limbo” while a former service provider decides whether or not to exercise remain on the cap table and dilute the ownership of other stock and option holders. As a result, companies generally want to see unexercised options terminate as quickly as possible so that the underlying shares become available for issuance to other service providers under the company’s option plan.

How companies can create flexibility in the post-termination exercise period

Companies that are concerned about the post-termination exercise window usually consider addressing it in one of three ways:

• Setting up the company’s option plan so that all options will be granted with a post-termination exercise period of more than three months.
• Amending all then-outstanding options to extend their post-termination exercise periods.
• Extending the post-termination exercise window for individual optionees.

While every company and situation is different, we usually suggest companies use the standard three-month post-termination exercise period and consider extensions on a case-by-case basis, as determined by the board of directors. This approach helps preserve ISO eligibility for stock options and prevents an excessive percentage of company equity from sitting “in limbo” as unexercised options. The board can still make exceptions for individual optionees – for example, because the company wants to accommodate a former team member leaving on good terms or as a benefit the company can offer as part of negotiations with a departing employee. Just keep in mind that extending the post-termination exercise period of a previously granted ISO is a modification that will result in the loss of ISO status, and if offering to modify a previously granted ISO, care must be taken to ensure the offer to modify the ISO does not remain open for more than 29 days, otherwise the option will lose ISO status even if the offer to modify the ISO is not accepted by the option holder.

Board and investor dynamics

Companies considering post-termination exercise period extensions should consider that many investors and investor-appointed directors have strong opinions about extended post-termination exercise periods and may view the practice as a red flag or otherwise ill-advised.  We encourage companies considering extended post-termination exercise periods to “know their audience” before making a formal proposal to their boards. Similarly, we encourage companies that will require future investment to anticipate that future investors and future investor directors may be similarly opinionated. This is not in any way to say that all investors disapprove of extended post-termination exercise periods, but rather to say that this can be a polarizing topic.

Special considerations for certain categories of optionees

The post-termination exercise period analysis may be different for non-employee service providers, like consultants and advisors, whose option grants are not eligible for ISO treatment, and who may only have been engaged to provide services for a limited period of time.

Furthermore, for optionees outside of the US, local law and tax considerations will factor in as well. For example, in the UK, in order for options to be eligible for treatment as “enterprise management incentive” (EMI) options (further discussed in this Cooley GO article), they must be exercised within 90 days of termination. US companies should discuss with local counsel when considering modifications to exercise periods for non-US optionees.