What is the post-termination exercise period (PTEP)?
Many startup employees receive stock options as part of their equity compensation. Those options carry the potential for lucrative upside in the future. But when an option-holding employee changes jobs, they’ll face an expensive short-term conundrum: Employees typically have just three months after leaving to decide whether to exercise their vested options. This interval is called the post-termination exercise period (PTEP) or post termination exercise window.
Depending on the strike price set in the employee’s option grant, exercising fully vested company stock options can cost thousands of dollars. If an employee can’t pull together the required cash and plan for the tax impact of the exercise before their PTEP elapses, they’re out of luck. All those vested options representing years of hard work will disappear back into the company’s option pool to be reissued to other employees.
The three-month PTEP poses real challenges to employees who want to benefit from equity ownership—and for companies that want to make ownership a meaningful part of their hiring and retention strategies. It also contributes to a gulf that exists between the value of vested stock options at private companies and the value of the options that employees ultimately exercise.
Unvested options: Nearly $2 billion in value lost to employees
The vested options that tech workers abandon each year add up to a very expensive missed opportunity. How expensive?
To answer that question, Carta analyzed data on in-the-money stock options from a sample of 386 private companies each valued at more than $1 billion. The results are striking.
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During 2022 alone, just shy of 50,000 workers at these companies walked away from fully vested stock options.
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Using a company’s current 409A valuation as a proxy for the price at which employees could have sold shares—a conservative estimate—the combined net value of the options they abandoned was more than $1.8 billion.
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Based on those 409A valuations, the average employee left more than $47,000 in stock on the table.
The origins of the 90-day PTEP
The vast majority of startups give terminated employees 90 days to exercise their options, regardless of whether an employee chose to leave or was asked to leave. In the above sample, 82% of companies have a median PTEP of between 89 and 92 days.
Where did the 90-day PTEP come from?
A 90-day PTEP is a boilerplate solution based on Internal Revenue Service (IRS) regulations for taxing stock options. Most companies that issue options use incentive stock options (ISO) for employees. The incentive is related to taxes: Exercising an ISO is not a taxable event, unless the holder is subject to the alternative minimum tax (AMT). Instead, employees will only pay tax when they sell any exercised stock in the future, which will be at capital gains rates so long as they hold the stock for at least one year from the date the option was exercised and two years from the date it was granted.
But this “incentive” tax treatment for ISOs only lasts three calendar months after employment ends—and yes, three calendar months can be between 89 and 92 days depending on time of year. If a company wants to give employees the flexibility to exercise stock options beyond three months, each ISO grant will no longer qualify for ISO tax advantages, and be taxed like a non-qualified stock option (NSO) grant if exercised after 3 months. The IRS taxes NSO grants at the time of exercise, in addition to when the employee sells any exercised stock in the future. Dealing with NSO tax treatment for ISOs can be expensive, time-consuming, and complex for both the company and the stockholder from a legal and tax perspective. A 90-day PTEP became the de facto standard because it doesn’t require the company or its employees to pay any additional taxes.
Pros of offering extended PTEP
From a company’s perspective, extending PTEP provides a few potential benefits:
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Fairness to employees: Removing the 90-day deadline for exercising vested options is a fairer way to treat employees, particularly during a time of economic uncertainty. Workers who have earned equity through their contributions to a company over many years shouldn’t lose out on that compensation because of a short-term cash crunch they may not have anticipated.
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Recruiting and retention: A longer PTEP signals to job-seekers and current employees that a company cares about its workers and their financial well-being.
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No golden handcuffs: Extending PTEP gives employees the freedom to to try something new. With a restrictive window, the need to earn enough cash to exercise options might keep an employee tethered to a job they would have otherwise left. This may lead to unmotivated employees that simply “rest and vest” while they await an exit.
Cons of offering extended PTEP
Offering extended PTEP also comes with obstacles. The potential downsides include:
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Increased dilution: Offering extended PTEP can increase dilution. Under the 90-day model, any shares that are unexercised after 90 days return to a company’s option pool and can be reissued. Extending PTEP means it will take longer for options to return to the pool, so some companies might need to expand their pool of employee options to keep up.
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Administrative burden: In addition to tracking ISO disqualifications, amending existing grants might also subject some employees to increased tax obligations because of the ISO $100k rule.
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Increased employee tax obligations: The taxes due at the time of exercising an NSO or disqualified ISO grant are on the “income spread,” which is the difference between the exercise price and the current fair market value of the stock. As the valuation of companies grows, so does the tax obligation due at the time of exercise. This may lead to options going unexercised due to how expensive it may become to exercise the option without an accompanying liquidity event to sell some of the resulting stock. Companies will also owe withholding taxes on the exercises by employees or may require employees to front those taxes, which can create administrative complexity.
Extended PTEP is on the rise, following venture slowdowns
Several major tech companies have extended their PTEP policies in recent years, including Pinterest, which now gives former employees up to seven years to exercise any vested options. At Carta, an employee’s PTEP matches the time they spent at the company: Someone who leaves Carta after three years would have three years to exercise their options.
Every quarter, Carta releases information on the startup ecosystem in our State of Private Markets report. Our most recent data showed:
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In Q4 2023, startup workers exercised just 23% of their vested options before expiration.
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The past three quarters have brought the three lowest employee exercise rates since at least the start of 2018.
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Throughout 2023, the percentage of options with a PTEP longer than 90 days remained high relative to recent years, reaching 20% in three of the past four quarters.
A PTEP longer than 90 days has historically been more common during periods of frequent layoffs or other economic hardships. So although layoffs and voluntary job departures grew increasingly less common over the course of last year, the high rates of extended PTEP in recent quarters are likely a sign of the stress caused by 2023’s venture slowdown.
Conversely, an increase in PTEP correlates with a decrease in the rate of employees choosing to exercise their vested options. Employees executed just 23% of their vested options during Q4 2023, compared to 31% in Q4 2022.
What should employees know about PTEP?
The length of a company’s PTEP is an important part of your equity package. If you’re employed at a privately held company, make sure you know your company’s PTEP policy (detailed in your equity grant paperwork) so you can plan accordingly. You may want to consider saving a little of each paycheck to purchase your options so you aren’t hit with a big expense all at once. And don’t forget about the impact of year-end taxes on any exercise.
It’s also a good idea to look up how long you can enjoy the tax benefits associated with early exercise to decide if you want to exercise your options during your employment. And if you think your company’s PTEP doesn’t align with the company’s values, ask why company leadership decided on it in the first place. Maybe they haven’t questioned the default 90-day window, and someone needs to point that out.
Carta Equity Advisory helps the employees of our customer companies make informed decisions about equity ownership and taxes.
