A recent High Court case shows what can go wrong for private companies that structure options too generously.
Summary of Plumbly v Beatthatquote.Com Ltd  EWHC 321
Mr Plumbly was granted a discounted option to acquire 10% of the company's share capital. He exercised it after a year and left shortly afterwards, having fallen out with the founder.
The company refused to honour the option contract arguing his "misconduct" amounted to repudiatory breach of contract creating an implied term that his option could not be exercised whilst in breach. This argument worked for the employer in Tesco Stores v Pook  EWHC 321 where Mr Pook had defrauded Tesco by establishing a front company to which he required suppliers to pay bribes (for which Mr Pook was later imprisoned).
Mr Plumbly had not behaved anything like as badly as Mr Pook. The employer argued breach of a non-compete clause in his employment contract but the judge found there was no direct competition and the company had in any case agreed to the arrangement by a side letter shortly after Mr Plumbly joined.
The judge ordered the company to pay Mr Plumbly substantial damages whereas the company argued that (if it lost) it should be entitled to share settle the claim, so preserving cash within the business.
Beatthatquote.com was saddled with a substantial cash liability as a result of a giving in to the temptation of structuring options too generously.
Most private companies are not so generous as to grant discounted options which are exercisable immediately. Plan rules and articles have to be carefully considered as a whole to ensure they create an effective incentive and to protect employers if anything goes wrong.
The most common approach is to provide that options only become exercisable on an exit and lapse on cessation of employment for any reason. This approach frees up share capital should participants leave, the freed up shares can then be used to provide incentives in order to recruit replacements and it also avoids the need to buy-out minority shareholders.
Some companies allow good leavers to retain the options until an exit (either in full or to the extent vested in accordance with a schedule) with a discretion to treat bad leavers as good ones. This approach gives employers some leverage when negotiating termination packages as it enables companies to offer option retention at no cash cost.
A minority of companies, however, allow options to be exercised pre-exit. In these circumstances the articles need to be reviewed to ensure leavers are required to offer their shares for sale on cessation of employment. This approach creates the problem of how to fund the costs of buying back shares from leavers. The common solution is to establish an employee share ownership plan trust which is put in funds by loans from the company, the shares so acquired are used to source future share awards.
We act for Colin Buchanan and Partners Limited which went much further by establishing a very successful employee share market (which was shortlisted for an ifs ProShare Award in November 2008). Click here for details of how the market works. The market not only absorbed shares from leavers, it was so successful it solved the company’s succession issues by transferring over a third of the share capital from retiring directors to the next generation of management and key employees in less than 5 years.
We also act for many US companies that take a more generous approach to equity release (although still not as generous as the option granted to Mr Plumbly). As a quid pro quo for "employment at will", US employees expect options to be subject to a vesting schedule. Leavers are typically permitted to exercise their vested options for a short period after cessation and to retain the option shares.