Private companies which want to consider implementing a stock option plan need to be aware of the legal considerations involved. This article will outline some of the principal considerations.
Why - A share option plan can be an effective way of incentivizing employees by providing an additional form of compensation over and above standard salary and benefits compensation.
How - An option plan sets aside a prescribed percentage of the equity ownership of the company to be issued to employees who are granted options by the company’s board, typically on an annual basis.
Granting and vesting - Options are usually granted subject to vesting conditions. The most common vesting condition is continued employment with the company and the typical vesting period is 3 or 5 years. The employee pays nothing for the option grant; the consideration provided by the employee is the continued value of his or her employment services.
The option is granted, for both tax and business reasons, at the fair market value (fmv) of a share of the company at the date of the grant, i.e. if that fmv per share is $20, the option exercise price when granted would be $20. The value to the optionholder will be realized later when an option is hopefully exercised at a point that the fmv per share has increased and the employee will have a benefit equal to the difference between the option exercise price and the value of the share acquired at the time of exercise.
Exercise of Options - Vested options are typically exercisable by an optionholder on the occurrence of certain “liquidity” events such as termination of employment or death of the optionholder or a sale or IPO of the company. The option plan often provides that on a sale or an IPO, unvested options enjoy accelerated vesting, i.e. otherwise unvested options automatically vest, so that the employee can fully benefit from the occurrence of that liquidity event.
Realization of Options - The realization of an option can take place through the purchase by the optionholder of the shares underlying the option at the option exercise price and the sale of those shares back to the company (or to a third party purchaser in a company sale transaction) or through the repurchase by the company of the vested options themselves. The choice between these alternatives is often based on tax considerations.
Other Considerations for the Company - Other significant considerations for the company which need to be taken into account in implementing an option plan (in addition to the dilution of the equity interests of the other owners) are that optionholders who become actual shareholders:
(a) are entitled to receive financial statements of the company each year and therefore become aware of the financial information and condition of the company to a much greater level of detail than would otherwise usually be the case in a private company
(b) will have attendance and voting rights at shareholder meetings unless the class of optioned shares is a non-voting share class, and
(c ) will have equity interests that may affect a sale process, e.g. where the buyer of the company wants to acquire 100% of the company’s equity.
These issues are typically addressed in a form of shareholders’ agreement that each optionholder must agree to enter into before exercising an option and acquiring actual shares. That agreement will also typically provide for the repurchase of an employee’s shares on the termination of the employee’s employment for any reason.
FMV Determination - One important consideration is how fmv of the company shares is determined for the purposes of option grants and share purchases each year. Alternatives include an fmv determination by the board, a formula-based determination using the company’s annual financial statements and a third party sale price, where there is an available arm’s length third party transaction in a relevant time period.
Summary - The above is a general description of some of the most common legal considerations of a share option plan. There are also important tax and business considerations as well.
In another article we will review considerations involved in a phantom share option plan and a comparison of the 2 different approaches.