How do we process an option exercise by an employee?
Takeaway: First the employee tells you they want to exercise, then you coordinate their payment of the exercise price and have them sign the option exercise notice, and lastly we update the cap table to reflect the exercise.
In general, startup employees do not exercise stock options unless (i) they leave the company and want to purchase their shares or (ii) the company is acquired in which case the options are typically either automatically paid out or are underwater and expire. When a startup employee decides to exercise their stock option, it triggers a series of steps that the company must take to process the exercise and issue the shares. Here is a general overview of the standard procedure for processing an option exercise by a startup employee:
Notification: The employee notifies the company that they want to exercise their stock option. They typically send the founders an email and the founders pass it along to their lawyers. The lawyers then provide a written notice for the employee to sign, specifying the number of shares in their option that they wish to exercise, and an agreement to be bound by certain share restrictions contemplated by the equity incentive plan.
Payment: The employee pays the exercise price for the option, usually by check or wire transfer.
Confirmation: The company confirms receipt of payment and the exercise notice.
Processing and Issuance of Shares: The company’s lawyers process the exercise on the company’s capitalization management platform. If you use Carta, the employee will receive a notification asking them to accept the shares. If you use Shareworks, their stock holdings will be an entry on the cap table.
Record Keeping: The company updates its records to reflect the issuance of the shares and provides its accountants and the employee with any necessary tax forms, such as a Form 3921 for incentive stock options or a Form 1099-B for nonqualified stock options.
An important note about processing stock option exercises for terminated employees or consultants: they must be completed within the applicable post-termination exercise period. This is typically 90 days or 3 months but can vary depending on the terms of your equity incentive plan.
It is important for startups to have clear procedures in place for processing option exercises, including deadlines for exercising options, acceptable forms of payment, and procedures for confirming and processing exercises. Additionally, it is important for the company to maintain accurate records of all option exercises and to ensure compliance with all applicable securities laws and regulations. I generally recommend that startups include their lawyers in the option exercise process.