Stock option plans and agreements: what to think about for your company

As a tech startup, you may be approached by employees, contractors, or directors (known collectively as "Consultants") 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 Consultants 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 Consultant 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 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 Consultants to potentially receive option agreements, and sets out the company's intention to give Consultants options.

The option agreement

Once a company has established an option plan, and it wishes to give options to a Consultant, the company must enter into an option agreement with that Consultant. The option agreement is specific to each Consultant or "optionholder" and gives 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, and that specific 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 option agreement to option agreement.
• The Option Pool: The stock option plan will set out the total number of options (which will eventually, possibly, 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. The Exercise Price must reflect the fair market value of the shares on the Grant Date or the company may face additional tax consequences for issuing the option agreement.
• 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 options are not exercised after fully vesting and before the Expiry Date, the options are forfeited and return to the Option Pool.

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. This discretion must be exercised honestly and in good faith.^[1]

Vesting Schedule

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 vests all at once or pro rata over a prescribed period of time. For example, a one-year vesting schedule with a one year cliff would mean:

• 1/4 of all of the options under an option agreement vest (are available for purchase) on the first anniversary of the Grant Date
• 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:

1. The passage of time (time-based vesting);
2. The achievement of performance goals (performance-based vesting); or
3. 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 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. If the optionholder is a Consultant for the company, it usually makes the most sense that they (or their estate) would decide whether they intend to become a shareholder immediately rather than waiting for the Vesting Schedule to be complete.

Most stock option plans provide that options vest so long as the Consultant continues to provide active service to the company. If the Consultant 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.^[2] 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.^[3]

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 too many options are included 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, Consultants may not be happy with the amount of options being offered, forcing founders to add more options to the Pool.

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 rising 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 changed later on 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, have different priority to dividends, or have a set value, among other decisions.

Conclusion

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.