Do nonqualified stock options need term limits to be exempt from deferred compensation (409A) treatment?

Question

Suppose that I want to build a startup with independent contractors and want to compensate them with non-qualified stock options (NSOs). I expect the business to take some time to stabilize and become profitable, and I do not want to force the contractors to prematurely exercise their options and pay income taxes on the stock received before the business is a proven success.

I therefore would like to set the NSO expiration date to, say, 20 or 30 years from grant date, rather than the usual 10. For similar reasons, I would like to omit (or greatly extend) the typical requirement that NSOs be exercised within 90 days of leaving the company.

Is all of this possible while still keeping the NSOs exempt from 409A treatment? (A variety of online articles discuss stock options and 409A—see here and here for examples—but I haven't yet found any that give a clear answer to this question.)

Answer 1

Interesting questions. Let's start with the simpler question: the requirement that options be exercised within 90 days of service termination, while very common, is frequently waived especially in the case of independent contractors. That shouldn't present a Section 409A issue.

As to longer term options - I have to say I havne't seen one before. While it's clear that the maximum term for a qualified stock option is 10 years, I'm not aware of any limit on the term of nonqualified stock options, and I don't see anything in the Section 409A regulations that would indicate that, as long as the general rules are complied with, the longer term would cause a problem. In any case, most of the stock option plans contain boilerplate language that states that, if it is later determined that a provision in the option or plan somehow violates Section 409A requriements, that provision would be automotically and unilaterlly modified to bring it back in compliance. So, if later it becomes clear that a 10 year option is the longest term under Section 409A, any option that has a longer term would automatically become a 10-year option.

Just make sure your lawyer includes a provision like this in the plan document...

Having said all that, I would add that you may want to rethink the idea of running around handing extremely long terms options right and left like popcorn. While it's a great tool for a start up looking to receive services without spending too much cash, this practice quickly gets out of hand and becomes cumbersome. If your business is successful, future investors may well be reluctant to deal with a company that has dozens of people on its cap table, many of whom had only a fleeting contact with the company years ago. Something to think about.