There are several.
One is to do nothing. The employee had 10 years to exercise their options. If the company wanted to take a hard line, it could say, “Sorry. Your options expired.” As a practical matter, that’s not a good solution, because the options are likely held by someone who is valuable to the company. So, we recommend against this approach.
Second, if the first grant of stock options expire, the company could grant new stock options. But those new options must be reset at an exercise price that’s equal to current market value. Section 409A of the IRS tax code says the exercise price of a new option, on the grant date, has to be no less than the fair-market value of the company stock (the value established by a 409A audit firm). While this approach certainly attempts to provide the employee with a wealth creation opportunity, it usually comes at a significantly higher cost because the original grant was likely a pennies/share price and the new grant is often a many dollars/share price. While new options can theoretically be structured to have a discounted exercise price while not running afoul of the Section 409A rules, most companies find the required structuring to be impractical and therefore unworkable.
A variation on this approach is that the company could grant restricted stock units (RSUs) for an equivalent (or lesser) number of shares under the expired option. With an RSU, the employee eventually takes ownership of the stock at a future liquidity event, without having to pay the exercise cost. However, upon taking possession, he is still going to have the tax bill. Furthermore, companies and employees often have a hard time agreeing on the terms of the conversion, namely around what is the value of a share of stock and how many ISOs equal how many RSUs.
Third, a company may want to help the employee to exercise their stock options by facilitating a cashless exercise via a company buy-back. Employees sell some of their to-be exercised shares to cover the exercise cost and to pay their taxes. But the company is basically purchasing shares at that point, so it’s real money coming out of the company’s balance sheet to fund the employee’s tax bill.
A variation on this approach is that the company could allow option exercises using a promissory note. The company would loan the employee the money for the exercise and tax costs. But again, the company would have to use its balance sheet for the taxes. It’s not a cash-free transaction.
And there are some other restrictions around promissory notes. These kinds of notes are typically only provided to an officer or director of the company or sometimes to a small handful of employees who have a common circumstance. In any case, a company can’t have any outstanding loans to officers or directors as it becomes a public company. Once the company proceeds towards its public offering, it’d have to take care of that note before filing an S-1. There are also limits on the number of outstanding loans a company can carry.
Lastly, a company could give bonuses to employees to cover the exercise and tax costs. One thing to note with bonuses is that a company can’t require that they be used to exercise options. If the employee would rather use those funds for something else, that has to be allowed. If the bonus can only be used to exercise the option, then that raises a 409A problem. And, obviously, the company may want (or have) to use its cash for purposes other than employee bonuses.