The end of 2022 and the beginning of 2023 have been filled with news of tech layoffs, including the notable FAANG companies (Meta, Apple, Amazon, Netflix, Alphabet) and smaller, privately held companies. The cause of these layoffs is multifaceted, including increased cost of capital through higher interest rates, inflation, less optimistic economic forecasts, and over-hiring during prosperous times. Tech industry workers often receive some form of equity compensation, and this equity compensation can often be a significant portion of an individual’s total compensation package. These recent tech layoffs are a reminder that both employers and employees should review the provisions of their equity inventive plans and award agreements from time to time. This article will describe the common terms in an equity incentive plan or award agreement that may be implicated by the termination of an employee or service provider who received an equity compensation award (each an “award recipient”) and how specific types of equity compensation may be impacted by a termination.
Plan and Award Agreement Provisions Commonly Implicated by Termination
The only way to know for sure how a termination will impact an award recipient’s equity compensation award is to read the applicable document containing the terms and conditions of the award, typically this is a plan document and associated award agreement, but in some cases the equity compensation award may be granted through an employment agreement or other standalone document. Some award recipients may have received more than one equity compensation grant and, in this case, the terms of each award may or may not differ. Common provisions that may come into play in the event of termination include:
Typical Impact of Termination on Equity Compensation Awards
In the event an award recipient is terminated, equity compensation awards are typically handled as follows (though the terms of a specific plan or award may provide otherwise and, in such case, control):
Nonqualified stock options (NQOs) and Incentive Stock Options (ISOs), typically vest over three to five years (though some award agreements may provide for shorter or longer vesting periods). Most often, an award recipient’s termination without cause will result in the forfeiture of any non-vested NSOs or ISOs, as of the date of such termination. Any NSOs or ISOs that vested prior to the termination date usually remain exercisable for a period of time after termination. This post-termination exercise period is referred to as the “PTE Window.” The PTE Window for NSOs is typically around 90 days but can be longer or shorter depending on what is provided in the plan document or award agreement. The PTE Window for ISOs is capped at 90 days by the Internal Revenue Code (Code). Some equity incentive plans will provide that if an award recipient is terminated for cause (as defined in an employment agreement or in the plan document) they will forfeit both vested and non-vested NSOs and ISOs as of the termination date (if vested NSOs and ISOs have not yet been exercised).
If an award recipient exercises their NSO within the PTE Window, the difference between the fair market value as of the date of exercise and the exercise price will be taxed as ordinary income and included in the award recipient’s taxable income. ISOs exercised during the PTE Window will not be taxed on exercise and any tax on a future disposition will be determined based on the applicable holding period requirements under Code Section 422.
If as part of a separation agreement or settlement agreement the company and award recipient agree to additional vesting of NSOs or ISOs beyond what the plan or award agreement ordinarily provides for, such agreement must be completed prior to termination as the reinstatement of forfeited NSOs or ISOs after termination will result in a new option being granted. The grant of a new option means that the exercise price used in the prior option needs to be updated to at least the current fair market value of the company’s stock, effectively eliminating the spread between the fair market value and the exercise price of those NSOs or ISOs that additional vesting was negotiated for.
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