Even though stock options are a commonly used compensation tool, certain issues, such as whether you must/should limit their terms and, if you do, whether you can make changes to their terms after they have been granted, still catch some employers by surprise.
Do we need a term on our options?
Yes, if they are intended to be Incentive Stock Options (sometimes called ISOs) under Section 422 of the Internal Revenue Code (the Code), then the plan or award agreement must provide that the ISOs are not exercisable more than 10 years after the date of grant (five years if the employee is a 10 percent shareholder). Also note that, although it does not have to be reflected in the plan or award agreement (like the 10-year term does), employees must actually exercise ISOs within three months following termination of employment (or within one year following termination of employment if the termination is due to the employee’s total and permanent disability) in order to preserve the tax-favorable status of their ISOs.
Nonqualified Stock Options (sometimes called NSOs) are not required to reflect a particular term under applicable tax law.
Do we want a term on our options?
Probably. Even if you are not required to include a particular term on your options (because they are NSOs), you may want to include one so that: (1) the options do not provide unlimited upside to employees, (2) you limit the accounting expense related to the options (the longer the term, the greater the accounting expense), and/or (3) you minimize the risk that the options will be subject to the Employee Retirement Income Security Act of 1974 (ERISA). Under ERISA, a “pension benefit plan” is generally defined as a plan that can include individual agreements that defer payment until termination of employment or beyond. Therefore, there is a risk that ERISA will apply to options that may be exercised at any point from the grant date until the employee terminates. Option terms of 10 years or less minimize this risk.
Many employers also choose to place limits on how long employees are permitted to exercise options following termination of employment in order to: (1) limit the upside benefit to terminated employees as a result of subsequent appreciation in the value of the awards and/or (2) help employees preserve the tax-favored status of their ISOs (see above). For this purpose, 90 days following termination of employment is a fairly typical limit. This is also one way to describe the period of time during which the offer to exercise the option remains open, which is one of the requirements that must be met in order to ensure that the option is exempt from Code Section 409A.
Can we change the term of our options?
Maybe. This question generally comes up in two contexts – (1) an executive is running up on the 10-year term of her option but does not want to exercise yet or (2) an executive terminates employment but would like additional time to exercise and, in both cases, the company would like to accommodate the requests.
If the options are ISOs that already provide for the maximum 10-year term described above and the company and executive would like to preserve the ISO status, then the answer is always no. If you extend the term, then the options will no longer qualify as ISOs.
If the options are NSOs (or were originally intended to be ISOs, but no longer qualify) that are structured to be exempt from Code Section 409A (almost all options are), then the term may only be extended in limited circumstances without adverse tax consequences:
- If the NSO is “underwater” – i.e., the fair market value of the underlying stock on the date of the extension is less than the exercise price – then the term may be extended without any limits, unless the plan provides otherwise.
- If the NSO is “in the money” – i.e., the fair market value of the underlying stock on the date of the extension is more than the exercise price – then the term may only be extended to the shorter of (1) the original term or (2) 10 years from the date of grant, subject to any additional limits set forth in the plan. Any extension beyond these deadlines will likely subject the employee to an additional 20 percent income tax, and the employer to additional reporting responsibilities, under Code Section 409A.
For example, if the original term was seven years and the option is “in the money,” then the term may not be extended beyond the original seven-year term, but, if the executive terminates in year three, then the employer could amend the option to waive a requirement that it be exercised within 90 days following termination of employment without subjecting the executive to additional taxes, as long as the terminated executive is not permitted to exercise the option beyond the original seven-year term. If the original term was 12 years, then the term may not be extended beyond 12 years but, if the executive terminates in year three, then the employer could amend the option to waive a requirement that it be exercised within 90 days following termination of employment without subjecting the executive to additional taxes, as long as the new term does not extend beyond 10 years from the date of grant.
[Note: This rule can be confusing because, even though a NSO is not required to include a maximum 10-year term when it is granted, the term may never be extended beyond 10 years from the date of grant.]
So, just like in politics, keep “term limits” in mind when you are dealing with stock options!