The turbulent economy is impacting the way startups do business. The bear market, steep inflation, and global volatility have many companies instituting a variety of cost-cutting measures, such as consolidations, IPO delays, hiring freezes, and layoffs. If you’re among the unfortunate thousands affected by recent layoffs in Silicon Valley, you might be wondering about the status of your stock options.
The law doesn’t provide any special protection for employee stock options. Your authoritative resource for understanding the details of your equity compensation package, including what happens in case you’re laid off, is your plan agreement. In this article, we’ll describe some possible answers to this question, identify the information you’ll need to find in your plan agreement, and discuss considerations when deciding whether and when to exercise.
Are your options vested?
Generally speaking, employees retain only vested options when their employment ends; any unvested options are lost. Plan agreements often contain exceptions, however, and layoff is sometimes among them. Additionally, companies that wish to take care of employees they feel compelled to lay off may offer enhanced severance benefits, which can include accelerated vesting and/or extension of the period during which options may be exercised after the end of employment.
Was your employment terminated?
In some cases, a layoff might not amount to termination. If you continue to work for the company as an outside consultant or if you’re placed on furlough, for example, these situations could have different impacts on the status of your options. It all depends on the content of your plan agreement, so if you have a continuing connection to your employer, check for provisions that could potentially preserve your options in this way.
What kind of options or shares do you have?
Compensation plans can provide employees several different types of equity. What happens when employment is terminated depends in part upon what type of equity is involved.
Incentive stock options (ISOs) can be granted only to employees of the issuing company and receive special tax treatment. When an employee exercises an ISO, the cost of exercising the option (the “strike price”) is commonly below the current fair market value. The difference between these two prices is called the bargain element. Unlike the exercise of other types of stock options, exercising an ISO does not automatically trigger tax liability based on the bargain element. Instead, this amount is included in the alternative minimum tax calculation. If the employee holds the resulting shares for at least one year after exercise and at least two years after the ISOs were granted, then proceeds from the sale are treated as long-term capital gains.
IRS rules stipulate that holders of ISOs have up to 90 days after termination to exercise vested incentive stock options. Individual plan agreements may give employees more time than this; however, ISOs that aren’t exercised within 90 days of an employee’s termination lose their special tax treatment and become non-qualified stock options (NSOs).
Non-qualified stock options can be granted not just to employees but also contractors, vendors, consultants, and others connected to the granting company. When NSOs are exercised, the bargain element is taxable as wage income. Plan agreements are more likely to contain provisions that allow exercise of vested NSOs more than 90 days post termination, and they may allow exercise for as long as ten years after the grant date.
Employees who have vested shares of restricted stock retain rights to those shares at termination. Any unvested shares are typically lost at termination.
Clawback provisions grant companies the right to buy back shares from employees after certain triggering events, such as separating from the company. This can include involuntary, non-cause-based separations like layoffs. These clauses can pertain not just to options but also to vested shares. Check your plan agreement for words such as “repurchase,” “forfeiture,” or “redemption.” This language is commonly used to describe clawback policies, which often give companies the right to buy back shares at the exercise price or at the current fair market value. If your company is pre-IPO, this could significantly hinder your ability to profit from your shares.
If you can exercise, should you?
Whether you should take the opportunity to exercise options before it’s gone depends on your financial readiness to do so as well as your company’s outlook.
Having a tax professional knowledgeable in equity compensation prepare a tax projection is almost always a good idea. Exercising NSOs will change your W-2 and AGI for Federal and state purposes, and may impact other parts of your tax return. ISOs may dramatically increase AMT resulting in large tax bill with penalties. Should you incur a significant tax liability, you may be less prepared to pay following a layoff.
On the other hand, if your company’s future looks bright, it may be worth taking out a loan, if necessary, to make the investment. Be aware, however, of the possibility that a price decline could put your shares underwater after you exercise—and what that would mean for your financial stability. For more general advice about navigating stormy market conditions, view our blog: Tips for Staying on Course During a Market Downturn.
WRP specializes in helping employees through the pre- and post-IPO process with fiduciary financial, investment, and tax guidance. For more insight into making the most of the opportunity your equity compensation provides, subscribe to our blog or check out our free resource library.