From my position as a late stage provider of employee liquidity, I often see what works and what doesn’t when it comes making money at start-ups. After looking at hundreds of individual situations, I would like offer one piece of advice to departing executives. The absolute best thing you can ask for when leaving a company is a long option exercise period.
Why is a long option exercise period so important?
When an employee leaves a business, usually the company informs the employee that they have 90 days to exercise their options. Even for early stage companies, the employee usually must come up with thousands of after-tax dollars to exercise their options and pay any tax that is due at the time of exercise.
As we all know, the large majority of all start-ups fail. Let’s assume, for sake of argument, that 99 out of 100 start-ups will fail in ten years and 1 will have an exit greater than $100M. If an employee has options on 1% of a company, the expected value of the options in any particular company is 1% * 1% * $100M or $10,000.
Therefore, at the time of exercise, there is a very low probability of an exit that is substantial enough to warrant putting after-tax cash at risk. Obviously, there are many factors that go into the precise value of the option, but when these odds are considered, it’s no wonder that many options are simply left on the table. And, I would argue, that people who exercise stock in any individual start-up in year one or two are probably making a bad bet with their hard-earned capital.
The best way to deal with poor odds that an individual start-up will probably fail, but may succeed in a big way, is to have a long time to watch before an employee must put cash at risk. That is where the long option exercise period comes in. Let’s say hypothetically an employee has 10 years to exercise their options, and all companies either succeed or fail in 10 years. In that circumstance, the employee will never lose their money. Rather, they will wait until company success is clear.
The other advantage is that giving an employee a long option period doesn’t really cost the company much. Sure, the company must wait to obtain the exercise price, but at an early stage, this amount of money is nominal. Usually, a long exercise period is a pretty easy ask. Smart entrepreneurs and early employees should always ask for a long exercise period when they move on.
In the last year, I have seen two situations in which long (5 year+) exercise periods have worked to entrepreneur’s advantage to the tune of many millions of dollars. In both circumstances the company took six or seven years to become successful. The original team was able to wait and obtain a substantial payday without putting their cash at risk.
So ask. It can’t hurt, and may be one of the best questions you every asked.