Should You Vest Only at a Liquidity Event?

partnersBy Corey Rosen. Alicia worked for a great entrepreneurial company. As a promising young marketing staffer, she was excited to get non-qualified stock options that she hoped could be worth a lot of money not too far down the road. The options had a six-year vesting rule, by which time she would have the choice to use after-tax dollars to exercise the awards and get the options, paying income tax on the spread. But Kevin, the owner, assured her that by that time, the company would go public or, more likely, be sold to a well-heeled buyer, so she’d never actually be out of pocket.

But things didn’t go as planned. An IPO turned out to be as unrealistic for Alicia’s company as it is for most start-ups, and potential buyers were not that attractive. Kevin worried as well that the purpose and vision he had for the company would not survive a new owner. Meanwhile, the value of the shares had increased substantially.

So Alicia had a choice. She could exercise now and be out of pocket the after-tax dollars she needed to buy the shares, plus the tax on the spread, meaning over half the value of the award effectively went up in taxes.  Or she could avoid the out of pocket cost and let the options lapse.

Alicia and Kevin are apocryphal, but all too common. We talk to lots of entrepreneurs who think employees will be very happy to become owners at a steep discount, even if they have to take a current loss on the exercise. But behavioral economics teaches us that most people value losses (here the payment of taxes and the purchase) far out of proportion to potential gains. So for Alicia and many of her colleagues, exercising the option looks more like punishment than reward. Kevin could have given employees qualified options so they did not have to pay taxes until sale, but they still would have to use after-tax dollars to buy stock, could face an AMT obligation, and would have the risk of having to hold the stock for a year. Restricted stock and restricted stock units also require tax costs of one kind or another, even though there is no purchase requirement.

An alternative is simply not to vest until a liquidity event. Few entrepreneurs I talk to have ever been told that is something they can do. If a liquidity event seems too far off, a halfway house is to do a net exercise, where the employee gets the value of the exercised award net of acquisition and tax costs. The payment is in shares, not cash, limiting the company’s cash flow hit. Employees see no loss that way and become actual owners.

In this, as in many other design issues, entrepreneurs need to be aware that there is an asymmetry in how most employees view stock awards and how most entrepreneurs view being owners. For entrepreneurs, ownership is what it is all about; for employees, it is only part of the picture, a part that carries risks and rewards.

coren rosenCorey Rosen is the lead author and editor of The Decision-Makers Guide to Equity Compensation, which explores the gamut of design issues for stock awards for entrepreneurial companies.