Accelerating stock options

Someone recently asked me about stock options:

How do they generally work when stock hasn’t vested and the company undergoes a change of control? Do the options immediately vest? Are they lost?

The typical model is that the vested options are either exercised, net exercised, or paid as if net exercised. In short, they’re paid out just as any other shares (but on a net basis since the exercise price has to be taken into consideration). Unvested options are usually assumed by the buyer and converted into options as part of the buyer’s plan. If the buyer doesn’t have a plan, or doesn’t want to take the options, the seller’s option plan controls. Many plans provide for acceleration of some or all of the unvested options in this situation.

What about full accelerated vesting on a change of control? Isn’t that the way to cash out, you ask? I realize now I should have subtitled this post “don’t be greedy; don’t be foolish.” A typical Silicon Valley startup employee option plan provides for “double-trigger” acceleration, meaning full acceleration would happen only after (1) a change of control and (2) termination by the buyer without cause within 6 months. The purpose of this provision is to treat employees fairly by giving them an opportunity to continue to earn their vesting by working while at the same time continuing to give the selling company the benefit of the incentives that are already in place. If every employee’s options accelerated, the buyer would have to issue new options or provide other compensation to account for the loss of that incentive. If that’s hard to imagine, consider an employee who has a guaranteed bonus of $10,000 paid at year-end. If the company gets sold in November, and the employee’s bonus goes away, to the employee, that feels like a $10k loss. If it stays gone, the buyer will have to do something to keep the employee’s incentives roughly the same. That’s the first half of the scenario; the flip side is that if the company gets sold in January and the bonus gets paid out 11 months early, the buyer will have to provide something extra to give the employee the incentive to perform for the remainder of the year. That additional expense, if any, is going to be figured into the purchase price in almost all situations. TANSTAAFL.

So, attempting to be greedy as a set of employees results in a lower price in any case because the buyer has to provide more incentives. Taking options away from employees as a greedy set of shareholders results in a lower price because incentives have to be added. Over time, the startup market in Silicon Valley has settled on this double-trigger scenario as the most common way of balancing the various interests.

It’s much less common than people think for someone to get all their options to accelerate merely because of a change of control. Some senior executives will get this treatment as part of a pre-negotiated compensation package when a major goal for them is to arrange to sell the company.

Finally, there are quirks and tweaks if the transaction takes a different structure, but the principles are generally the same for vested options. In the case of an asset sale, the company will typically liquidate and unvested options just go away as often as they might be accelerated.