Why the Stock Option System Is Broken and Some Simple Ideas for Making it Work Better

By Mike Dinsdale, Chief Financial Officer, Gusto

Incentive stock options plans were originally designed to encourage employees to patiently help build startups over the long term. By leaving the company, they would forfeit a considerable amount of wealth.

But with the most successful startups staying private well beyond the old IPO windows—the median age of a company when it makes its IPO has grown from seven years to 12 years—the entrenched stock option structure can hurt both companies and employees.

Staying private longer makes a lot of sense for #breakawaygrowth companies. It allows them to focus on their operations and not worry about quarterly reports. It also means that more of the wealth creation goes to employees and early investors—the people who helped build the company.

The downside, which many companies only realize too late, is that the stock option structure, as currently designed, often doesn’t scale well beyond year seven. And it can create a variety of problems if companies don’t take steps to do something about it early.

To understand why, let’s first cover some basics. There are two separate costs for employees to exercise their vested options. The first is the purchase price. This is typically fairly low.

It’s the related tax liability that’s the crusher. Purchased options are taxed as income under the alternative minimum tax (AMT), a special tax structure that’s often triggered when people exercise options; the tax is assessed on the difference between the strike price and the 409A price, which can be a lot when a company’s valuation is skyrocketing. This can be many dollars per share. Many people simply can’t afford to pay it because, in all likelihood, their startup salary didn’t allow for socking away the kind of cash necessary for such a large transaction.

So, what happens in today’s highest-performing startups? Employees, all the way up the ladder, men and women who have worked incredibly hard to help build the company, are trapped. Here are a few scenarios where employees face either losing their hard-earned vested shares or face near financial ruin by having to come up with the cash for the exercise price and tax liability:

If the employee is a good financial planner, she might want to exercise her vested options in an effort to get those shares into long-term capital gains, which have a much lower tax rate. However, without the necessary cash, and if she thinks she’ll be subject to the AMT, she’s forced to hold and wait to exercise and sell at the same time. At a future date, foreclosing on her long-term capital gains savings when her tax bill will be at the higher ordinary income rate foreclosing on her long-term capital gains savings.

If an employee has no intention of leaving the company and is planning on patiently waiting for that future exercise and sale event, she’s going to come up against an ominous immovable wall with a federally mandated expiration of all options after 10 years. Today, employees across all kinds of private companies are starting to be forced into a very stressful and potentially demoralizing “use it or lose it” situation – all of this after a decade of loyal service to the company.

If an employee wishes to or needs to leave the company, she typically has 90 days, mandated by the company, to come-up with the necessary cash to exercise her options and the money to pay the AMT (if applicable) or face having them expire and absorbed back into the company. So people stay. But they can feel stuck. Employees find their hands forced if they want to take advantage of their stock option plans in these situations.

Then there are companies who can’t bring themselves to let an executive go because they’re no longer a fit. I’ve seen people kept on for years because the company cared about them, valued their contribution in the early days of the company, but didn’t want to put them in a use-it-or-lose-it situation. These people are often referred to as “vest in peace” as they’re shunted off to some far-flung part of the company in a low-impact role.

From my point of view, the antiquated options structure is incredibly unfair to those team members who have been steadfast contributors to the company’s success. How can someone come up with $100,000 or more, whether she wants to stay or it’s time for her to leave? Don’t employees deserve to have maximum optionality to create wealth for themselves and their families?

Solving the liquidity problem