It's Time to Change the Status Quo for Stock Options

How we designed a more employee-friendly equity plan

Adrian Macneil ·

7 min read

Published June 13, 2023

It's Time to Change the Status Quo for Stock Options

"I'm totally bored at my job, but I can't leave – I would owe over $300,000 in taxes!" My friend had joined an early-stage startup, and had seen moderate success over the past few years, causing the value of their stock options to increase tenfold – a life changing amount of money. But if they left, they would be required to exercise their stock options within 90 days, or forfeit them entirely. And while exercising the options was not particularly expensive, it would trigger an Alternative Minimum Tax (AMT) bill that they simply could not afford.

It struck me that while this situation was bad for them, it seemed equally bad for their employer – what company would want an employee doing the bare minimum at a job, simply because they couldn't afford to leave? Yet their employer had also made it difficult to sell their shares on the secondary market – the usual way to get liquidity from a pre-IPO startup.

Many of today's stock option practices date back to the 1990s – the heyday of the dot-com era, when companies often went from incorporation to IPO in less than 4 years (e.g. Amazon was founded in 1994 and went public just 3 years later, eBay was founded in 1995 and also went public in 3 years). However, these days it is common for startups to take 8–10 years before an IPO or liquidity event. Over the past decade as an employee at several startups (including two hypergrowth "decacorns"), I have seen countless instances where these stock option plan features from the 1990s have caused poor outcomes for both employees and employers. And ironically, the more successful a company is, the more challenging it can become for its employees.

An organization is nothing without its people. This is especially true at early stage startups, where each and every team member has a meaningful impact on the success or failure of the company. As CEO, my highest priority is to attract and retain the absolute best people for our team. With that in mind, I'm going to share a few non-traditional decisions we made at Foxglove that I think significantly increase the potential outcomes for our employees.

Note that this is written from the perspective of a US-based, VC-backed startup, and likely will not apply outside of that context. Of course, this post should not be treated as tax or legal advice.

Golden handcuffs

The most notable problem with many stock option plans today is the "golden handcuffs" my friend encountered: most stock options are set to expire 90 days after you leave a company (regardless of whether you leave on good terms or not). This means that within 90 days of leaving the company, you must either walk away from your entire stock grant, or come up with cash to exercise. Worse, if the company has done well (and gone up in value since you joined), you must also pay tax to the IRS on the difference between the option strike price and the current Fair Market Value (FMV), which can be an order of magnitude more than the price of your (still illiquid) stock. This unfairly benefits employees who are independently wealthy and can afford to take this risk, and negatively impacts those who cannot afford to exercise. They are "golden handcuffs", because many employees simply cannot afford to leave their job without forfeiting their stock. For example, some early employees at Uber were forced to take out loans from family members to cover these costs, without any guarantee that they would ever see a return. During the dot-com bust, some employees paid millions in taxes, only to receive stock that was eventually worthless.

As outlined by Zach Holman in Fuck Your 90 Day Exercise Window, the solution to this is relatively simple: extend the post-termination exercise deadline beyond 90 days. Data collected by Zach indicates that forward-thinking companies are now choosing to extend their post-termination exercise period from 90 days to anywhere from 1 to 10 years (the IRS-allowable maximum). Some companies choose to pair this with a minimum tenure requirement for the extended exercise period (typically 2–3 years).

Now, there are some technicalities: according to the IRS, Incentive Stock Options (ISOs) must expire after 90 days, so in order to last longer than that, they must be designed to automatically convert into Nonstatutory Stock Options (NSOs). Secondly, it is not possible to retroactively add this automatic conversion feature for existing grants, so they must either convert to NSOs immediately (slightly worse from a tax perspective), or be converted on a case-by-case basis after each existing employee leaves. These issues can be solved by company legal counsel, but are easiest to implement early in the company's lifecycle to avoid the pitfalls of retroactive changes to existing grants.

So why don't more companies do this? The answer is simple: it is worse for the company's existing stockholders (founders, investors, and other employees). If employees leave and do not exercise their stock options, those options return to the pool, and can be reissued to future hires. If employees keep their stock options, then the equity pool must be increased for new hire grants, diluting existing shareholders. Scott Kupor of A16z exemplifies this line of thinking by arguing this creates "Dead Equity":

The logical equivalent to the NFL's dead money problem is "dead equity" in a startup. A startup that elects, for example, to extend the option exercise window for departed employees is actually creating dead equity at the expense of the "live equity" held by the remaining employees. Just as dead money disadvantages the remaining team members, so too does dead equity affect the remaining employees and resource allocations a startup is able to make (no matter where the company falls on the GAAP vs. non-GAAP accounting-for-options debate).

Personally, I find it hard to imagine any employee being upset by departing colleagues being allowed to keep their vested stock options. In fact, I think many employees would be surprised to learn that they are not entitled to keep their vested options after leaving – if you work at a startup, check your option agreement today!

At Foxglove, our stock option plan initially allowed for 90 days post-termination exercise, which is unfortunately the default when incorporating through services such as Clerky. However, today we are extending this to 10 years post-grant – the gold standard and maximum allowable by the IRS. We are offering this to all employees after 2-year tenure, which I believe strikes a nice balance by being as employee-friendly as possible to those who make a meaningful contribution to Foxglove (and who are most likely to be affected by significantly increased FMV at exercise). For existing employees, since we cannot change the terms of already issued ISOs, we will offer this benefit via one-off amendments as they leave.

Vesting

At early-stage companies, it is almost ubiquitous for both employees and founders to receive an equity grant that vests over 4 years with a 1 year cliff. As mentioned earlier, this was a sensible choice during the dot-com era, when successful companies would IPO in less time than that. However, in the modern startup environment, it is a dated practice.

Not everyone will stay at a company longer than 4 years, but if they do, they will reach the end of this vesting period. Some companies provide "refresh grants" – additional stock grants for existing employees. However, after 4 years of growth, these grants typically come with a higher strike price and fewer shares, leading to a "vesting cliff". Many employees end up leaving after 4 years, because their refresh grants are insignificant compared to their original grants.

At Foxglove, our solution is to grant additional years of equity upfront: 6 years instead of 4. For the avoidance of doubt, this is only beneficial if it is implemented as "50% more equity with 50% longer vesting" – not just longer vesting on the same amount of equity. For employees who stay less than 4 years, this makes no difference. But for those who choose to stay longer, this is a huge benefit to lock in more equity at a low strike price, with minimal cost to the company (since the dollar value of equity is lower in the early days).

As a startup grows into later stages, it may no longer make sense to have such large upfront equity grants, so I suspect we will not keep this policy forever. Later stage employees are taking significantly less risk, so I think it is sensible to have something closer to annual grants based on a target compensation (e.g. as Stripe and Coinbase did). But during the early stages of growth, employees taking a bet on a small startup should be appropriately rewarded with meaningful upfront grants, and I think 6 year grants are a great option for other early-stage startups to consider.

We also set founder vesting at 6 years, for a similar but different reason. Extended vesting for founders aligns incentives between co-founders, and between founders and their investors. In case a founder leaves after only one or two years, this ensures that they do not walk away with a disproportionate amount of vested stock. Everyone should be compensated for their contribution to a startup's success, but not to the extent that it causes issues for remaining founders, employees, or investors. While we opted for 6-year vesting at Foxglove, I would recommend future founders consider even longer (e.g. 8 or 10 years). This demonstrates to your fellow co-founders and investors that you are committed for the long haul.

Early exercise

Finally, a little-known feature of some startup equity plans is Early Exercise. This allows employees to purchase stock options before they vest (with an obligation to sell unvested stock back to the company if they leave). Why would you want to do this? It comes with obvious risks – if the company is unsuccessful, the value of your stock may become worthless. However, there are significant tax benefits to exercising your stock immediately after it is granted. Since the strike price and FMV are equal at grant time, there is no upfront tax due upon exercise (provided you file an 83b election at the time of exercise). Later on, when the stock is sold, it will be taxed at the much lower Capital Gains rate, rather than Income Tax or AMT rates.

Early exercise also unlocks an even lesser-known tax benefit: Qualified Small Business Stock (QSBS), which offers investors of certain early-stage startups up to $10 million in tax-free capital gains if stock is held for 5 years from purchase. This can be an incredible benefit for both founders and early-stage employees.

Early exercise is not for everyone – it requires upfront investment, with the risk of losing your entire investment, for potential future tax savings. However, the upfront investment for early employees can be relatively low, and the potential tax benefits if a company is successful can be massive. It's not offered by default in most startup equity plans, as it requires additional work for company legal counsel, and has gotchas for employees early exercising ISOs. But I personally know many early employees who benefited from early exercising options, and believe it should become standard practice for every company to at least offer this to their employees.

Employee-friendly equity at Foxglove

In summary, at Foxglove we've implemented the following non-standard practices to make our equity program better for our employees:

We're extending our option exercise period from 90 days to 10 years (the maximum allowable by the IRS), available after 2 years tenure.
We offer 6 year up-front equity grants (with 1 year cliff). Founders are also on this 6 year vesting cycle. We will continue to offer this for all Series A-stage employees, although we may revisit it as the company grows.
We offer early exercise. Choosing whether to take advantage of this is a personal decision, but we make the option available to those who are interested.

I'm thankful to our investors and board for supporting these changes, and I strongly believe they make us more attractive as an employer. I hope more founders will be inspired by this post to consider challenging the status quo of stock options by implementing similar policies.

If you're interested in joining Foxglove, please check out our open roles!