Ninety Days to Find the Money or the Options Disappear
Employees who leave a startup typically have three months to exercise vested options, paying the strike price and frequently a large tax bill on paper gains. Many cannot, and the equity they earned lapses.
What Happens on the Last Day
An employee with vested stock options who leaves a company faces a deadline written into the plan. Standard practice, inherited from tax rules governing incentive stock options, gives ninety days from termination to exercise.
Exercising means paying the strike price for every share, in cash, to a private company whose stock cannot be sold.
For an early employee with a low strike price and a modest grant, that might be a few thousand dollars. For an employee at a company that has grown substantially, the exercise cost can be tens or hundreds of thousands.
The Tax Makes It Worse
The exercise cost is only part of it, and frequently the smaller part.
For non qualified options, exercising triggers ordinary income tax on the difference between the strike price and the current fair value, payable immediately, on shares that cannot be sold to fund it.
For incentive stock options, no ordinary income arises on exercise, but the same spread is an adjustment for alternative minimum tax purposes, which can produce a substantial liability on a paper gain.
| Item | Cash Required |
|---|---|
| Strike price on all vested shares | Immediate |
| Ordinary income tax on the spread | Immediate, for non qualified options |
| Alternative minimum tax on the spread | Next filing, for incentive options |
| Ability to sell shares to fund it | Generally none |
An employee who did the work and vested the shares is asked, on ninety days notice, to write a large cheque for an illiquid asset in a company they have left. A great many decline, and the equity returns to the pool.
Where the Ninety Days Came From
The window is not arbitrary. Tax rules provide that an incentive stock option must be exercised within three months of termination to retain incentive treatment. Beyond that it becomes a non qualified option.
Plans therefore adopted ninety days as the default, and it propagated as standard documentation regardless of whether the grants were incentive options at all.
The result is that many employees hold non qualified options, where the tax rationale does not apply, under a ninety day window copied from a rule that governs a different instrument.
Who Benefits From the Lapse
When options expire unexercised, the shares return to the option pool and are available for future grants.
That reduces dilution for existing shareholders relative to a world where every departing employee exercised. The benefit accrues to investors and to remaining employees, funded by the departing employee losing equity they had earned.
Whether that is appropriate is genuinely debated. One view holds that equity is intended to retain people and somebody who leaves should not keep the upside. The other holds that vested equity is earned compensation and a deadline that makes it unaffordable is a forfeiture in substance.
The Extended Window
Some companies extend the exercise window substantially, commonly to seven or ten years from grant, and the practice spread after several prominent companies adopted it publicly.
The consequences are real and go in both directions.
For the employee, an extended window removes the cash deadline entirely. They can wait for a liquidity event and exercise then, funding it from the sale.
The costs are that any incentive stock option converts to a non qualified option ninety days after termination regardless of the extended window, so the favourable tax treatment is lost anyway. Existing shareholders bear more dilution, since the overhang persists for years. And the cap table carries former employees as potential shareholders for a decade.
Companies adopting it generally regard the dilution as the price of a compensation package they can defend, and several have paired it with lower grant sizes on the reasoning that the equity is now worth more.
The Alternatives
Several other mechanisms address the same problem partially.
Early exercise permits exercising before vesting at a low strike price when the spread is minimal, which removes the future tax problem entirely and requires cash upfront on shares that may not vest.
Company tender offers periodically allow employees to sell some shares, which provides the liquidity that makes exercising affordable, and depends on the company choosing to run one.
Third party exercise financing provides cash to exercise in exchange for a share of the eventual proceeds. It works and the effective cost is high, reflecting the risk that the shares end up worthless.
Restricted stock units avoid the problem structurally, since there is nothing to exercise, and they carry their own issues around double trigger vesting and taxation at settlement.
What an Employee Should Do
Read the plan before accepting the offer, not on the way out. The exercise window, whether early exercise is permitted, and whether the company has run tender offers are all knowable in advance and are rarely discussed in an offer conversation.
And model the exercise cost including tax at a realistic valuation, because the number that matters is not the notional value of the grant but the cash required to keep it.
The Bottom Line
The ninety day exercise window originated in a tax rule for one type of option and became the default for all of them, and it converts vested equity into a cash decision most employees cannot fund. The shares that lapse return to the pool and reduce dilution for everybody who stayed, which is the quiet transfer at the centre of the arrangement. Extended windows fix the problem and cost the company dilution, which is why the practice spread among companies competing for engineers and remains far from universal.