Managing Former Employee Equity: Compliance and Best Practices

The average American will switch jobs 12 times in their working life, and your employees are probably not the exception to this trend. Hence, you cannot afford the luxury of not planning how equity compensation is to be treated in case of employee exits.

Careless treatment of equity compensation doesn’t just strain relationships and impact reputation but also leaves the door open for tax penalties.

Best Practices for Managing the 3 Common Forms of Former Employee Equity

When an employee leaves, they can hold vested options, unvested options, and stocks gained from exercises. In this section, we will discuss how companies should approach these three types of securities to ensure a tax-compliant and amicable exit.

Treatment of Vested Options

If an employee exits before exercising their vested options, they will have an opportunity to do so in the post-termination exercise period (PTEP). The duration of the PTEP depends on your equity compensation agreement. Typically, this period lasts for about 90 days.

However, there are companies like Quora that offer a PTEP of 10 years.

According to Forbes, some companies even allow for PTEP extensions to indicate that they are acting in good faith, even with existing employees. For instance, Square offers an extended PTEP if the employee completes at least 2 years of service.

When an employee exits, you must communicate PTEP details transparently to avoid resentments and disputes. This will allow your employees to raise funds for stock option exercise should they plan to do so.

Another key piece of information you must communicate is that if stock options are exercised more than 90 days after exit, they will be treated as non-qualified stock options (NSOs) even if they were initially structured as incentive stock options (ISOs).

Your company can also choose to repurchase vested options.

Treatment of Exercised Options

If you do not wish former employees to hold ownership stakes in your company, you can offer to buy back their shares. But there’s a chance that former employees will decline buyback offers if they expect share price growth.

Hence, some companies may include a clawback clause in equity compensation agreements that allows them to forcefully buyback shares from former employees. These clauses are included to avoid having to welcome new shareholders in case of third-party sales. This minimizes the control-related risks.

There’s another plausible rationale for enforcing clawback provisions. Companies may believe that allowing a former employee to benefit from future share price growth is the same as continuing to compensate them even after termination.

However, if you do not foresee any risks from letting former employees hold your company’s stocks, you don’t necessarily need to buy back said shares. After all, buybacks, whether forced or voluntary, will deplete your cash reserves.

Treatment of Unvested Options

From a tax compliance perspective, forfeiture of unvested options is the best practice. Under Section 409A, acceleration of payments is not permitted. So, if you treat unvested options as vested, you could allow employees to benefit from stock options, but, simultaneously, you will also trigger tax penalties.

Specifically, acceleration of payments in non-qualified deferred compensation (NQDC) plans triggers immediate taxation of vested income, higher-than-normal interest on unpaid taxes, and a 20% tax penalty.

You must explain these tax consequences clearly to your former employees. Then, you should treat unvested options as vested only if the employees believe the expected benefits comfortably outweigh the tax consequences.

For instance, suppose a former employee held unvested options to purchase stocks worth $10 million for $10,000. We will assume that these options were granted 2 years ago. If you treat these unvested options as vested, the former employee will owe the following penalties:

Penalty	Calculation
Immediate taxation of vested income	Immediately taxable income × Marginal tax rate = ($10 million - $10,000) × 37% = $9,990,000 × 37% = $3,696,300
20% penalty	Immediately taxable income × 20% = ($10 million - $10,000) × 20% = $9,990,000 × 20% = $1,998,000
Interest	Immediately taxable income ×{[1+(1% + Underpayment rate)] ^ Years since grant -1} = ($10 million - $10,000) × {[1+(1%+7%)] ^ 2-1} = $9,990,000 × {[1.08] ^ 2-1} = $9,990,000 ×16.64% = $1,662,336

So, the former employee could owe $7,356,636 in taxes just because their unvested options became vested post-termination. In such cases, the former employee is highly likely to demand immediate buyback so that they can pay the tax bill.

If that’s not possible for your company, the former employee will have to either sell their shares to a third party or pay the taxes with their savings. Unless the employee has already identified and solicited a seller or sees enough upside to comfortably bear the tax bill, they would not prefer vesting of unvested options.

Eqvista – Robust Equity Data Infrastructure for Informed Decision-Making!

Your company should document its post-termination extension period (PTEP), buyback and clawback provisions, and proposed treatment of unvested options across all equity compensation plans. This will prevent triggering tax penalties, control-related risks, and disputes that occur with unrehearsed terminations.

Modern cap table management platforms like Eqvista streamline this process considerably by providing a centralized virtual data room. We enable your team to swiftly and securely access sensitive agreements so you can prepare the necessary documentation for your post-termination playbook.

Our platform also offers various other features like 409A valuations, round modelling, and filing support that are essential for navigating funding rounds and tax compliance.

Contact us to know more!