Can I give an employee a longer period to exercise their option?
Takeaway: While you can extend the post-termination exercise period beyond the standard 90 days, doing so for an Incentive Stock Option (ISO) will trigger its automatic conversion into a Non-qualified Stock Option (NSO), creating a significant negative tax consequence for the employee.
The standard 90-day post-termination exercise period (PTEP) can be a major challenge for departing employees. They are forced to make a significant financial decision—whether to spend potentially thousands of dollars to buy stock in an illiquid private company—in a very short timeframe, often right after losing their job. In response, some employee-friendly companies have begun to offer a longer exercise window, such as one, two, or even ten years.
While this is a generous and attractive benefit, it is not a simple policy change. Extending the PTEP has a profound and often misunderstood tax consequence that can turn a tax-favored Incentive Stock Option (ISO) into a less-favorable Non-qualified Stock Option (NSO).
The ISO 90-Day Rule
The tax code has a specific and strict rule that governs ISOs. For an option to maintain its status as an ISO (and its potential tax benefits), the employee must exercise it no later than 90 days after their termination of employment.
If the company's stock plan gives an employee the right to exercise their ISO more than 90 days after they leave, that option, by operation of law, automatically converts into an NSO on the 91st day.
The Tax Consequence of Conversion
This conversion from an ISO to an NSO can have a major negative tax impact on the employee.
As an ISO: If exercised within the 90-day window, the employee generally pays no ordinary income tax at the time of exercise.
As an NSO: If the employee waits and exercises the option on, for example, day 91, it is now an NSO. At the moment of exercise, the "spread"—the difference between the fair market value of the stock and the exercise price—is taxed as ordinary income.
Example:
An employee leaves and has a vested ISO to buy stock at $1 per share.
At the time they leave, the stock's fair market value is $10 per share.
If they exercise within 90 days (as an ISO): They pay $1 per share and have no immediate tax bill.
If they exercise on Day 91 (as an NSO): They pay $1 per share, but they must also immediately recognize $9 per share ($10 FMV - $1 exercise price) as ordinary income and pay the corresponding taxes in cash.
The Strategic Decision for the Company
The decision to offer an extended PTEP is a strategic trade-off.
The Pro: It is a major benefit that can help you attract and retain talent. It gives employees more flexibility and reduces the "golden handcuffs" effect where an employee is afraid to leave because they cannot afford to exercise their options.
The Con: It creates significant administrative complexity in tracking the conversion of ISOs to NSOs and managing the associated tax withholding and reporting obligations. It also means you will have a larger number of former employees on your cap table for a longer period of time.
If you choose to offer an extended exercise window, it is absolutely essential that you clearly communicate the tax consequences to your departing employees, ensuring they understand that the benefit of more time to exercise comes at the cost of losing the favorable tax treatment of their ISOs.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.