When Laying off Employees, Here’s How to Include Equity in Your Severance Packages
The past two-plus years have been a rollercoaster for companies, employees, and the market. While the pandemic ushered in a wave of layoffs in 2020, the landscape quickly changed in the tech sector. 2021 turned out to be a record year for startup fundraising and successful initial public offerings (IPOs). Many employees (and especially those at tech startups), saw their hard work start to pay off in the form of equity. Illiquid stock options became public shares they could sell. What, for many employees, is often a confusing part of their compensation packages suddenly became a potential windfall. Many employees at late-stage startups started paying attention to their stock options and hoping their turn would be just around the corner.
Unfortunately, things came to a halt in 2022, as the public markets began a reset that trickled down to the private markets. Numerous companies that planned to IPO in 2022 are now in a holding pattern. Still, many employees have a newfound appreciation for their equity, even if the IPO window could be shut for 18-24 months and not reopen until sometime in 2024 or beyond.
The bear market also affected the private market. Venture capitalists (VCs) started shutting their wallets and startups could no longer rely on fundraising to keep them going. Many need to cut costs to lengthen their runways due to lack of funding options—but also to prove they can become profitable in a time when growth will be harder. Unfortunately, headcount is usually the largest financial cost, especially when many also hired aggressively during the past couple years.
Layoffs are generally a last resort, and there’s never an easy way to do it. For all the discussions about severance packages and COBRA, equity and stock options are not always top of mind for founders. But they are often a significant portion of employee compensation packages, and departing employees may still want to invest in the future of the company they helped to build.
If you find yourself having to conduct layoffs, below are three actions to consider for your departing employees when it comes to their equity—and one for when you start to hire again.
1. Remove the vesting cliff
When granting stock options to employees, the typical vesting schedule is four years with a one-year cliff. Meaning, they don’t start to vest until one year after the employee’s start date, with the rest vesting monthly for the following three years.
For those who haven’t been with your company for a full year, this could mean that they lose the opportunity to exercise, or buy, any of their stock options—even if they’ve been with the company for 11 months.
Many companies, like Stripe, have removed the vesting cliff as part of their severance packages. This allows employees to immediately vest that initial 25 percent of their equity grant if they are laid off before they reach their one-year work anniversary. It provides departing employees with the option to exercise at least a portion of their equity grants, if they choose to do so.
Note that removing the vesting cliff likely involves or requires approval from your legal counsel and board of directors, and will also require some administration updates for those employees in your equity management software, like Carta or Shareworks.
If the administrative tasks and board approvals necessary to remove the vesting cliff aren’t feasible, companies could consider providing a cash payment for the pro-rated value of the equity that a departing employee would have earned if the vesting cliff had been removed.
2. Extend the post-termination exercise window
Most startups and private companies typically only offer 90 days for employees to exercise any vested options if they leave the company. For those who are being laid off, this can be painful since the cost to exercise can be prohibitive. For example, employees and founders we worked with in 2022 needed an average of $846,000 to exercise. Most of that is due to taxes.
With that in mind, you may consider extending the post-termination exercise (PTE) window. Instead of providing only 90 days, your severance package can include an extended exercise window of six months, two years, five years, or even ten years.
Many companies already do this. For some, this opportunity triggers upon reaching a certain milestone. For example, employees who remain with the company for at least two years may get a five year exercise window if they decide to leave the company.
If your company offers incentive stock options (ISOs), those convert to non-qualified stock options (NSOs) after 90 days. While this is less-than-ideal because NSOs are taxed less favorably than ISOs, it still gives your employees more flexibility to make a decision about their equity. If the company is a success, then less favorable tax treatment is still better than losing the equity they worked hard to earn.
It’s vital to communicate this to employees receiving an extended window. I have seen cases where employees were unaware that their ISOs converted to NSOs and received a surprise tax bill that left them feeling bitter.
Similar to removing the vesting cliff, changing the exercise window will likely need approval from your board of directors, and you’ll also need to update the changes for your employees in your equity management platforms.
If you do decide to offer an extended window, or an accelerated vesting cliff, be sure to clearly communicate in severance agreements that it may be “subject to Board approval” if you haven’t formally attained that approval yet.
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3. Offer transition services that include financial planning resources
Many companies offer transition services as part of their severance packages. These tend to be focused on job placement services to help employees land a new role. Consider topping up the standard transition services package by including financial planning resources as well.
At the end of the day, figuring out equity is hard, especially when it comes with a layoff. Making financial decisions is difficult and complicated for most of us, even for those who understand how it works (namely that it costs money to exercise and that there are often taxes due on top of the cost to exercise). Plus, everyone’s financial situation is different—so when it comes to equity, the cost to exercise, the tax implications, and ability or comfort level with financial risk will differ from employee to employee.
Offering access to a financial professional, like a financial advisor or a tax professional, to help them understand their equity and make an informed decision about it can be a significant, and much needed, resource for your departing employees.
4. Ongoing equity education
This isn’t one you can offer as part of severance packages, but educating your employees about their equity is an important—and inclusive—best practice for leadership.
Often, this begins with the offer letter. Provide as much information as you can to help your employees understand the potential value, and also how it works. In addition to just the number of options they’ll receive, consider including:
- The type of options they’re receiving
- The strike price
- The current 409A valuation
- The current value of their options
- The potential value if the company reaches certain valuation milestones
- The post-termination exercise window, so employees are not surprised if or when they decide to leave the company
You can also offer employees resources to better understand how equity works. (I’m biased, but Secfi Learn is a great place to start). Onboarding programs can include the basics of equity:
- What is a strike price?
- What is a 409A valuation (or fair market value)?
- What is the Alternative Minimum Tax (AMT)?
- Where to find grant information (for example, Carta or Shareworks)
- How are taxes calculated?
- What must be reported for taxes (since it’s often the employee’s responsibility)?
Also, communication is imperative for your employees. When it’s possible (and permissible), provide advance notice about events that may result in a change to your 409A. For example, this commonly occurs when a startup raises a new round of funding. During this time, there is usually a blackout period when employees will be unable to exercise stock. Providing notice allows them to make a decision to exercise (or not) in advance of the blackout period if they think the 409A will go up (or down).
Companies are legally required to conduct a 409A valuation once per year (at a minimum), so let your employees know when this may be happening. While it may not be as feasible to communicate about a funding round, give employees as much information as you can about any situation that could impact their cost to exercise, the 409A, or an upcoming blackout period.
Typically, the valuation goes up. But, in these market conditions, it could actually be beneficial to consider reevaluating your 409A in advance of the deadline (every 12 months) if you think it could result in a lower valuation. A lower 409A could decrease the taxes owed when employees exercise, and could also allow you to offer more attractive equity compensation grants when you pick up hiring.
Equity is not only a compensation benefit, it is also an investment decision for your employees. By choosing to exercise their options, they are deciding to invest in the company. But it’s also a financial decision, which can be complicated and often comes with a significant tax bill.
Giving employees basic information does not mean you are recommending that they exercise (or not exercise) their options. It just means you are giving them the tools and resources to make a decision. It not only helps them better understand, and value, a significant portion of their compensation, it can also speak volumes about your company’s culture and values.