Show Me Stock Options!
“Show me the money!” – a refrain often made by professional athletes and employees alike. Despite this demand, a start-up or scale-up company may not be in a position to show new employees all the money they desire to see due to the company’s cash constraints. The payment of stock options offers an alternate form of compensation on top of, or instead of, any monetary compensation.
Stock options provide an option holder with the right to buy a company’s shares at a pre-determined price per share. It is a form of equity compensation which incentivizes workers to drive and accelerate growth in a company.
The two main legal documents which govern stock options are (1) a stock option plan, and (2) a stock option agreement. This article provides an overview of both documents and gives you an understanding of how stock options work as a form of equity compensation.
Stock Option Plan
A stock option plan sets out the overall structure of the plan and specifies how a company’s option plan will be administered by the board of directors. Below are some main provisions of an option plan.
A stock option plan will specify which individuals are eligible to receive stock options. Typically, employees, consultants, advisors and directors are eligible to be granted stock options.
- Fixed Plan or Rolling Plan
A stock option plan can be set up as either a “fixed plan” or “rolling plan.” In a fixed plan, the company reserves a specified number of shares that may be subject to the plan. Under a rolling plan, the company reserves a certain percentage (e.g., 10 – 20%) of the total number of company shares issued and outstanding that may be subject to the plan. For example, a company with a 15% stock option pool and 10 million shares issued and outstanding would have the ability to grant up to 1.5 million stock options.
Start-up and scale-up companies typically implement a rolling plan since the number of stock options that may be granted under the plan will rise commensurately as the company issues more shares over time.
An expiration period is specified for all stock options. In most cases, stock options will expire 10 years after the date of grant, at which point, the options will no longer be exercisable by an option holder.
- Treatment of Options Upon Exit
There are many scenarios under which an option holder may leave the company – whether it be through resignation, termination of services, disability, retirement, etc. For each type of exit scenario, an option plan will state how an option holder’s stock options will be treated. In particular, the plan will set out the vesting terms and termination date of the options.
- Change of Control
In a change of control situation (e.g., sale of the business, new majority owners, merger, etc.), a stock option plan gives the board of directors discretion in dealing with any outstanding stock options. However, the board’s discretion is limited to certain courses of action which are specified in the option plan.
Stock Option Agreement
Stock options are granted to an individual through the entering into of a stock option agreement between the individual and the company. A stock option agreement provides an option holder with the contractual right to purchase shares of the company at a fixed price and at pre-determined times in the future. Below are the main provisions of a stock option agreement.
- Number of Options
A stock option agreement will specify the number of stock options granted to an individual. For example, an option holder may be granted 100,000 stock options which will allow the option holder to purchase 100,000 common shares upon exercise of the options.
- Exercise Price
An exercise price is the price at which an option holder can purchase a company share upon exercise of an option. For example, an exercise price of $1.00 will allow the option holder to purchase one common share of the company for $1.00 upon exercise of the option. And, if, at the time of purchase, a common share of the company is valued at more than $1.00, then the option holder will have received an economic benefit, which is calculated as the share price (e.g., $1.50) minus the exercise price (e.g., $1.00).
- Vesting Schedule
“Vesting” refers to the period when stock options are available for exercise and shares can be purchased. In most stock option agreements, stock options are subject to a vesting schedule. This means that an option holder will only be able to exercise its options (i.e., buy shares) once the options have vested. For example, 100,000 stock options may be granted to an employee under a four-year vesting schedule, where 25,000 options vest after the end of each year for a duration of four years.
- Manner of Exercise
An option holder would be able to exercise its stock options by completing and submitting to the company a notice of option exercise form, which will set out the number of shares to be purchased and the exercise price per share.
In conclusion, for a company looking to grow and scale, stock options provide an invaluable tool for attracting and retaining talented and qualified workers while limiting the use of the company’s cash reserves. Option holders are invested in the long-term success of the company since their options (and shares, if exercised) become more valuable as the company’s share value rises over time.
This article is for informational purposes only and does not constitute legal advice. This article is limited in scope to the use of stock options by private companies in Canada. For information regarding the tax implications of the use of stock options, you should speak with a qualified tax advisor.