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Published: 2008-03-26

Stock Options and The Terminated Employee



A major concern of high-level employees terminated from their employment is the fate of their stock options.

The amount at stake is often several times the employee's salary, and may dwarf the amount of severance the company may offer. Executives should, therefore, have a solid understanding of stock option agreements when negotiating their exit strategy from a private company.

A stock option is the right to buy certain stock at a certain time at a certain price, known as the "strike price." Stock options can be an important component of a company's overall compensation system and are used to attract, motivate, and retain talented management personnel by providing them with a method of obtaining a long-term equity stake in a corporation. Option grants may also have significant tax advantages for the corporation or the employee.

Compensatory stock options fall into two categories: incentive stock options ("ISO's") and non-qualified stock options ("NSO's"). Incentive stock options are stock options which satisfy certain requirements of the Internal Revenue Code ("Code"). Stock options which do not qualify under the Code, known as non-qualified stock options, are both more simple and more common.

Corporate Currency

Stock options have been a ubiquitous part of corporate life in the 1990's, and, as characterized by the Wall Street Journal have become the "currency of a new corporate age." Over the last five years, the annual value of options granted to corporate executives has quintupled to $45.6 billion.

But executives who shrewdly negotiate stock options when their careers are on the rise may sell themselves short when they are shown the door and asked to sign a severance agreement. Even in a tight labor market, high-level corporate executives risk finding a pink slip on their desk. If this happens, they should be aware they may be able to renegotiate the terms of existing stock option agreements and that their employer may be willing to provide severance pay in the form of additional stock options.

Class Concerns

The importance of stock, stock purchase plans, and stock options as a form of compensation for executives and even lower level employees has been highlighted by two recent cases.

In a recent decision by the Ninth Circuit Court of Appeals, Vizcaino v. Microsoft, 173 F.3d 713 (9th Cir. 1999), the Court reversed a judgment against a class of temporary employees at Microsoft who claimed that they had improperly been excluded from Microsoft's tax-qualified Employee Stock Purchase Plan ("ESPP"). The Court held that they were not "independent contractors" and therefore may be entitled to tens of millions of dollars which they would have received as part of the ESPP.

In a similar case, Carter v. West Publishing, No. 97-2537 (M.D. Fla. 1999), a federal district court in Florida certified a class of up to 144 former female employees of West Publishing who were allegedly excluded from a "hush-hush, arbitrary stock remuneration plan" because of their gender.

ESOPs Examined

An ESOP, or Employee Stock Ownership Plan, is a retirement plan covering all full-time employees under which the employer holds company stock in trust in the employee-participant's names, ESOPs are usually subject to the Employee Retirement Security Income Act of 1974 ("ERISA"). Some confusion has arisen from the idea that "ESOP" might indicate "Executive [or Employee] Stock Option Plan." In contrast to ESOPs, however, employee stock options are not retirement plans and are not governed by ERISA. Rather, an employee stock option is simply a right to buy a given amount of company stock at a given price for a given period of time. Employee stock options are not referred to using the "ESOP" acronym.

Here are some suggestions for executive-level employees to maximize use of stock options:

  • Golden Parachutes. The best time to negotiate stock options is at the beginning of employment, and executives and their attorneys should confer to negotiate the best possible employment contract, including benefits such as stock options and a "golden parachute." As seen below, the definition of "termination for cause", "change control," and other issues can be of critical importance.

  • Obtain Relevant Documents. Stock Options are governed by several documents, typically a "Plan," an "Agreement," and sometimes "Amendments" to the Agreement. You should retain all of these documents in a separate file and have them available for your lawyer, along with any separate employment contract, when facing possible termination.
  • Try Renegotiating. Severance negotiations on behalf of very high-level executives are sometimes driven not only by the reason for the termination and possible legal claims, but also by personal relationships between the executive and the board of directors, including the board's desire to be perceived as "fair" and its concern for its own fate. In this context especially, terminated executives may be able to renegotiate the terms of their stock option agreements.

  • Converting Plans. Qualified stock option plans, or ISO's, are typically subject to strict guidelines which cannot be modified without risking the tax benefit status of the plan. What is not commonly understood, however, is that ISO's can sometimes be converted to non-qualified stock option plans in order to provide additional flexibility in crafting a severance plan.

  • Change the Exercise Period. The employee's first concern when facing termination is that the window of time in which to exercise previously vested stock options, the "exercise period," ends soon after the termination date. In some cases, the plan may allow up to a year, but most allow from one month to 90 days, depending on the reason for the termination. This will restrict the employee's ability to wait for the stock price to rise to a certain level, and may not allow enough time to wait out a cyclical downturn. For example, if the stock is "under water" (less than the strike price) for the entire 30 days, the options are worthless to the employee. Thus, extending the exercise period is one of the most important goals for a terminated employee in crafting a separation agreement. Another important alternative to extending the exercise period, and a favorite of executives everywhere, is to simply reprice the options at a lower strike price.

  • Accelerated Vesting. Another major concern of terminated executives is that, due to their departure, they will lose out on valuable future vesting of stock options under one or more stock option agreements. These are options which have already been "granted" but are not yet "vested." In this situation, the employee may be able to negotiate the acceleration of the vesting of certain stock options before leaving.

  • Concluding Concerns. Stock options can be an effective and creative way of bolstering severance pay in the event of a layoff or downsizing. It is important to remember, however, that there is not guarantee what options will be worth, as it depends entirely on the future price of the stock. In the event of a major economic downturn, stock options may actually become less valuable than they were over the previous decade. In fact, it is often preferable for the employer to offer additional money as severance in lieu of lost stock option opportunities by reducing the value of the options to cash. Furthermore, employers may be reluctant to award options to executives who are leaving the company because of the effect on remaining employees, both in terms of morale and in terms of allocating limited amounts of stock. After all, options are supposed to motivate and reward employees for future performance.
Another concern an employer may have with regard to requests to modify a stock option plan is a reluctance to modify a stock option plan is a reluctance to make any alterations which must be approved by the company's board or compensation committee or may have to be reported to the SEC. These reports are open to the public and often followed by the financial media. Statutory insiders have reporting obligations under § 16 or the Securities Act of 1934 whenever they receive stock or stock options as a part of a severance package.

Executives should keep in mind the nuances of their stock option plans when negotiating severance plans; be open to the possibility of renegotiating stock options; and determine whether repricing, extending the exercise period, or accelerating the vesting of stock options may be more advantageous than a simple cash payment. Although not all employers are willing to engage in such a discussion, the potential payoff for the employee can be significant.