Stock options – the right to purchase stock in the Company at a fixed price (“exercise price”) for set period of time-generate many of the questions facing a startup lawyer. This relates to the popularity of options as a way to compensate employees and contractors.
Benefits: Properly structured options are not taxable on grant. Companies favor options because they provide a method of compensation for service providers – employees or contractors. A service provider who receives an option can wait to pay the exercise price a time when the value of the underlying stock exceeds the exercise price (referred to as an “in the money” option). Alternatively, if the exercise price exceeds the fair market value, the option is “underwater” and the recipient need never exercise the option. Additionally, options generally “vest” over time, which means that the service provider cannot take advantage of the option until she has worked for a certain period of time specified by the Company. In this way options help to align the interests of service providers with those of stockholders by motivating employees to increase the value of the Company over a period of years.
Structural Elements: We have already several of the issues associated with option and other grants of company equity in the past but this is a rich area with lots to discuss. This week we discuss some structural elements for, and potential misconceptions about, options.
- Options Are Not Warrants – As a first step it helps to get the terminology on the same page. Often Company executives confuse “options” with “warrants,” understandably since each represents the right to buy stock in the future at a price determined today. However, an “option” generally refers to a grant to employees and contractors, or service providers, while a “warrant” encompasses a grant to an investor in connection with an investment. The difference matters for several reasons – including that warrants are typically given in reliance on a different set of securities law exemptions than are stock options. Distinguishing the terminology for these two types of grants will reduce confusion for all.
- Options Are Granted Under Plans – Options are granted under a plan that is adopted by the Board of Directors and approved by stockholders. While in theory a Company may grant an option without a plan, doing so creates a number of tax, securities, and state law risks, and we strongly advise against doing so. This means that the first step in undertaking an option granting program is the adoption of a Company plan.
- The plan is a formal document setting forth the characteristics of the stock option grants – including the standard vesting terms, the rules for buying the shares of stock under – or “exercising” – the option, the term of years of the option, and the treatment of the options on a sale of the Company.
- While we often refer to these plans these as “option plans,” they are typically broader in name and scope – such as “The Acme Company 2015 Equity Incentive Plan.” In addition to providing for options, these plans will provide for the outright grant of stock, sometimes subject to vesting (‘restricted’) and sometimes not (‘unrestricted’). They further allow for ‘stock appreciation rights,” which mimic stock options except that on exercise the recipient receives cash pegged at the stock value rather than the stock itself.
- Options Are Granted From a Pool – In approving the plan, the Board must also approve the “pool” of stock from which option grants, or the other rights described above, will be made. This pool represents shares of the Company held back to be available for the exercise of the option by the recipient.
- While pools often range from 10-20% of the total potentially outstanding ‘fully-diluted’ shares of the Company, the precise size of the pool requires careful consideration – consultation with advisors is recommended.
- “Fully Diluted Shares” refers to the total number of shares that would be outstanding if all of the shares in the pool were issued and outstanding, as well as warrants and most other rights to acquire stock.
That’s it for this week – but this just scratches the surface so hopefully you’ll find more in the future on options.
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