Stock options are frequently used by early-stage companies to attract and retain talented personnel to help them grow and succeed. They can be used to compensate directors, officers, employees and other service providers, and to reward them for the contributions they have made to the company, by giving them an opportunity to participate in the company’s future growth. Having a stake in the potential upside of the company helps incentivize personnel to stay with the company, work harder and focus on the company’s long-term growth. For the uninitiated, this additional form of compensation may, however, come with unforeseen strings or liquidity drawbacks not otherwise considered when accepting options as a portion of compensation.
This article seeks to provide the background necessary to demystify stock options and to better understand how they work and their basic terms.
What is a stock option?
Simply put, a stock option grants the holder the right to buy a certain number shares of the company at a certain price, generally, after a certain amount of time. Unlike shares, stock options do not represent ownership of the company or carry the rights incidental to such ownership (such as the right to participate in profits or losses, to vote at the annual meeting or to receive dividends). Rather, they represent a future right, subject to the terms of the option plan, to buy those shares at a discounted rate (assuming the value of the company has increased since the grant date).
What makes stock options appealing to employees and other service providers is that the purchase price (also called a “strike price” or “exercise price”) is fixed at the fair market value of the underlying shares at the time the options are granted. If the company is successful, its share price will rise, while the option holder’s purchase price will stay the same. This gives the option holder the opportunity to buy the shares at a lower price than they are worth at the time of the purchase.
Like shares, however, stock options are “securities” and are subject to securities laws. So, before you start granting options in your company, we suggest you consult a lawyer. Particularly if you intend to grant options to consultants or other service providers.
What is a stock option plan?
The foundational document that governs your company’s stock options is called the stock option plan (also known as an equity incentive plan). A stock option plan will establish the basic rules for the company’s stock options (such as to whom options can be granted, how options are granted, how many options can be granted, how options are exercised, and the respective rights and obligations of the company and the option holder). On receiving a grant of options, a holder will also receive a copy of the option plan, which may include, as appendices, additional agreements restricting the transfer and/or voting of the underlying shares once the options are exercised.
A stock option plan must be adopted by the company’s directors and, in some cases, approved by the company’s shareholders.
What is an option pool?
The option plan will set out the “option pool”, which is the maximum number of options that can be granted under the plan. Generally, the option plan will authorize the directors to grant stock options under the plan without seeking additional shareholder approval, as long as they stay within the limits of the option pool and the authority granted to them by the plan.
There is no hard and fast rule for how many shares should go into an option pool. The size of the option pool will generally represent a balance between how much dilution the current shareholders are willing to take on and the company’s need to attract and retain talented personnel. Since the company will issue additional shares when options are exercised, each current shareholders’ proportionate ownership stake in the company will be reduced each time options are exercised. The trade off for this dilution is the presumption that the option holders are adding value and contributing to the company’s growth (and therefore increasing its value). On the other hand, if the option pool is too small, the company may not be able to grant enough options to attract and retain the employees and service providers it needs to help it grow and succeed. Investors will also generally want a say in the size of the option pool to control the amount of dilution that will hit their investment.
The size of an option pool can be expressed as a floating percentage of the company’s then issued and outstanding shares (usually calculated on a fully-diluted basis) or set to a fixed number, which must then be amended as the number of issued and outstanding shares increases. Option pools can vary from as low as 5 percent to as high as 20 percent of the company’s current issued and outstanding capital, with a typical pool ranging from 10-15 percent. Companies may stray higher or lower, but should have a reasoned basis for doing so. The size of the option pool can be changed in the future if needed. What is most important when determining the size of your option pool is considering the company’s needs in terms of compensating individuals against the desire to not grant so many options that a large portion of your company is owned through underpriced options.
How are options granted?
With a stock option plan in place and room in your option pool, the directors of a company can start granting stock options. Before granting any options, you should consult your option plan to confirm any requirements for who is eligible to receive options. You should also consider how many options to grant, the exercise price (which will be the fair market value of the underlying shares on the grant date), and any vesting terms. We encourage you to consult a tax advisor when setting the exercise price of options and to be careful, particularly when setting an exercise price lower than fair market value of the underlying shares (as you will not actually be doing any favours to the option holders come tax time).
When you want to grant a stock option, the first step is for the board of directors (or its authorized designee) to authorize the grant. This can be done at a board meeting or with a basic written consent signed by all of the directors. The resolution authorizing the grants should set out the name of each option holder, the number of options being granted, the exercise price, the expiry date, and the vesting schedule and vesting commencement date (if any).
Once the board has authorized the option grants, the company needs to complete the grant, which includes issuing an option certificate or agreement and updating a register of outstanding options and option holders. The stock option plan will usually provide a form of option certificate or option agreement for this purpose. This document will be signed by an authorized signatory of the company (usually the administrator of the option plan) and the option holder.
What does vesting mean?
In order to incentivize employees and other service providers to hang around, stock options will usually vest (i.e. become exercisable) in tranches over time. This period of time is known as a vesting schedule.
The option holder can only exercise those options that have vested according to the vesting schedule imposed by the company. Some stock option plans will provide for a default vesting schedule. For example, options could vest over a four-year period with a one-year cliff. This means that no options vest until the first anniversary of the grant date. On the first anniversary of the grant date, one quarter of the options will vest and become exercisable. Thereafter, the options vest and become exercisable in 36 equal monthly installments until the fourth anniversary of the grant date. Alternatively, options might not vest until, or vesting may “accelerate” when, there is an exit event.
Another important consideration when setting the vesting schedule is the vesting commencement date. This is the day that the vesting schedule begins to run. For new hires, the vesting commencement date will usually coincide with the options holder’s first day of work with the company. Where an employee began work before the stock option plan was in place, however, the vesting commencement date might be in the past. In this case, the exercise price should be set to a price that is equal to the fair market value of the company’s shares on the grant date, not the past date, again to avoid a taxable event for the option holder.
What does it mean to exercise an option?
The option holder may exercise the portion or portions of the option that have vested at any time. An option is “exercised” when the option holder actually purchases the underlying shares from the company. The option holder must usually send the company a written notice (called an exercise notice), in the form attached to the option plan, specifying how many shares they want to purchase, together with payment of the purchase price for those shares. The option plan usually provides for a form of exercise notice that is included with the option certificate or option agreement that the option holder signs when the options are granted. Once the company receives an exercise notice and payment for the shares being purchased, and the option holder has satisfied any other requirements set out in the option plan (such as signing a shareholders’ agreement), the company must issue the shares to the option holder. This is usually done by a written consent signed by all of the directors of the company.
When do options terminate?
The unexercised portion of a stock option will generally terminate, and no longer be exercisable by the option holder, on the expiry date set at the time the option is granted. This is typically a period of five or ten years following the grant date. The stock option plan may also provide for earlier termination of a stock option in certain circumstances, for example, in the event that the option holder’s employment or engagement with the company is terminated, the option holder dies or is unable to continue performing their duties due to disability, or if there is a public offering or other exit event.
Stock options can be a great tool for early-stage companies to attract, retain and incentivize employees and service providers, but they are often not fully understood by employees accepting this form of equity as a portion of compensation or even the founders looking to grant them. This article is intended only to provide a high-level overview of some of the basic concepts related to stock options. Since stock options do involve some complexity, we strongly encourage you to seek the advice of a lawyer (particularly in regards to tax, securities and corporate law requirements) in order to avoid mistakes or missteps. If you have any questions about stock options or if they are right for your company, we would be happy to assist.