As a tech startup, you may decide to provide incentive compensation to certain employees (known collectively as "Recipients"), and in some cases contractors, or directors who inquire about stock options as a part of their compensation package, or even as their entire compensation.
For growing businesses, issuing stock options to Recipients can be a beneficial strategy for aligning their interests with those of the company, attracting and retaining valuable and qualified workers, and incentivizing specific performance in a competitive sector.
In this article, we focus on the basics of Recipient stock options, which give the optionholder the right – but not the obligation – to purchase the company's shares at a specified price at a future date under the terms of an option agreement.
The stock option plan.
Stock options are generally given or granted in accordance with the terms of a company's stock option plan. A stock option plan sets out the general terms that the company will set for Recipients to potentially receive option agreements, and sets out the company's intention to grant Recipients options.
The option agreement.
Once a company has established an option plan, and it wishes to grant options to a Recipient, the company must enter into an option agreement with that Recipient. The option agreement is specific to each Recipient or "optionholder" and sets out the specifics of that optionholder's rights to buy shares. Each option agreement will also set out any differences between the terms of the general option plan, the form of stock option agreement attached to the option plan and that specific option agreement.
Below are the key terms that need to be understood and considered in the context of an option plan or option agreement:
- The Grant Date: The Option Date or Grant Date is the date when each option agreement is entered into. This date will vary from one option agreement to another.
- The Option Pool: The stock option plan or resolution of the directors may set out the total number of options (which eventually may become shares) which the company can offer through option agreements. Shares reserved as part of the Option Pool cannot be used for any other purpose.
- The Exercise Price: Also known as the "strike price," this refers to the price the optionholder will pay to purchase the shares in the future. If the Exercise Price does not reflect the fair market value of the shares on the Grant Date the company/Recipient may face unintended tax consequences unless the option is granted by a Canadian-controlled private corporation and certain other tests are met.
- The Expiry Date: This is the date that an optionholder's right to buy shares under their option agreement ends. When options have vested an optionholder will need to decide whether to exercise the option and purchase shares. If vested options are not exercised by the Expiry Date, the options are forfeited and return to the Option Pool.
- The Vesting Schedule: This is the period during which the Recipient is entitled to exercise their option rights, and purchase shares. This term, and how it operates, is discussed in more detail below.
The option plan, and each option agreement, may include additional terms that modify any of the above, or create additional restrictions around the options or the shares. Terms contained in the stock option plan may provide that determinations may be made in the sole discretion of the board of directors.
Most stock options can only be exercised, and shares purchased, by each optionholder after a certain period of time. This timeline of when optionholders can exercise their shares is called a "Vesting Schedule."
Stock options may be structured so that awards vest on a variety of schedules including all at once, pro-rata over a prescribed period of time, or a combination of lump vesting and over a certain period of time.
A common vesting schedule would be a four-year vesting schedule with a one year "cliff" and pro-rata vesting for three years thereafter. A cliff refers to a period of time where no options vest, and then a larger quantity of options vest following the cliff period. In the case set out above, this would mean:
- 1/4 of all of the options under an option agreement vest (can be exercised and purchased) on the first anniversary of the Grant Date.
- After the first anniversary, 1/36 of the remaining options under the option agreement vest on the first of the month for the next 36 months.
- All of the options will have vested on the fourth anniversary of the Grant Date.
Stock options may vest as a result of:
- The passage of time (time-based vesting).
- The achievement of performance goals (performance-based vesting).
- A combination of both time and performance.
Vesting Schedules may also be subject to accelerated vesting. The acceleration of options refers to the occurrence of an event that causes stock options to vest more quickly than the Vesting Schedule would originally allow. For example, if the company is sold, a plan will often provide that any options that have not yet vested will vest on or immediately before the closing of the sale of the company, allowing optionholders to decide to exercise and become shareholders, and benefit from the sale of the company.
An accelerated Vesting Schedule can also occur as a result of death or disability of the optionholder allowing the Recipient or their estate to decide whether to become a shareholder, failing which the options expire.
Most stock option plans provide that options vest so long as the Recipient continues to provide active service to the company. If the Recipient is an employee, terms governing the optionholder's rights on cessation of employment must be clearly defined. Employees must be put on notice regarding the termination terms of their option agreement. If these termination terms are not properly drafted or flagged, the optionholder may remain entitled to continued vesting and the right to exercise throughout a common law or contractual notice period.
After vesting, the options must be exercised before the Expiry Date for the optionholder to receive the benefit.
Size of the Option Pool and class of shares
Startups should give careful consideration to the size of the Option Pool. If the Option Pool is too large, future investors may view the company as too diluted, other potential optionholders might feel they also need a larger number of options by comparison, and the founders may find they eventually need to consult with more shareholders to receive consent to take certain actions with the company. On the other hand, if too few options are included in the Option Pool, the company may not be able to provide competitive and timely incentives to Recipients.
Typically, a plan will set the Option Pool at 10 per cent of the company's fully diluted cap table, with the number of shares in the Option Pool increasing with every investment round. While the size of the Option Pool is a key consideration at the outset of developing a plan, it may be increased by board or shareholder approval.
A company will also need to consider the class of shares used in its option plan. Options can consist of non-voting or voting shares and are usually common shares. If the company has multiple classes of shares, or has considered having multiple classes of shares, consideration should be given to whether options should have their own class of shares, and whether such a class should be voting or have different priority or rights among other decisions.
While using stock options as a form of incentive compensation can have many benefits for growing startups, careful thought, discussion and time must be spent on creating an option plan that is right for your company.
To learn more about stock options and discuss which strategy is right for you, please contact a member of our team.