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.
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.
Save hours and headaches on HR tasks.
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 detailing an employee’s base salary and equity. Provide as much information as you can to help your employees understand the financial impact of their equity, and also how the process of cashing out 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.
Frequently Asked Questions
What are the tax implications of including equity in a severance package?
Including equity in your employees’ severance packages doesn’t necessarily increase your company's tax bill—but it can complicate your tax reporting. It all depends on the type of equity you offer and what changes you make, like whether or not you extend the post-termination window. If you accelerate restricted stock unit (RSU) vesting, for example, you’ll have to withhold a portion of your employees’ vested shares to cover taxes.
How should equity severance terms differ for voluntary resignations versus involuntary terminations?
You can keep your equity severance terms the same for all terminated employees, regardless of whether they quit or were laid off. Or you can give laid-off employees more favorable terms, and require employees who quit voluntarily to forfeit unvested equity. Offering accelerated vesting gives laid-off employees the chance to get more money in the wake of their termination, while extending the option periods gives employees more time to cash out their vested options.
Save hours and headaches on HR tasks.
Can equity in a severance package be conditioned on signing a release or non-compete?
Yes, as long as your state doesn’t have specific laws against it. During your severance negotiations, you can ask employees to sign a legal claims release that essentially waives their right to sue your company for discrimination or wrongful termination in exchange for receiving equity as part of their severance pay. You can require non-compete agreements, meanwhile, that explain that employees will only get their equity in a severance package if they don’t leave to work for a competitor.
How should equity included in severance be communicated to departing employees?
You should communicate an employee’s severance package in writing in a separation agreement. These types of agreements detail the final paycheck amounts and equity terms, like vesting and post-termination exercise windows. Make sure your employment attorney reviews the separation agreements to ensure they’re compliant with state and federal employment laws.
