Legal Briefs, conversations about the tech and startup world with Máire Cunningham, a partner at Beauchamps.
What are share options and why are they important?
A share option is the right to acquire a share in the future at a fixed price, and hopefully, by the time the option is exercised, the share is worth a lot more. Options can be very important for a startup in getting and keeping the best people where high salaries or bonuses might just not be realistic. Companies grant share options to reward and motivate employees through potential company ownership. There are other employee share incentive arrangements but granting options may offer a company more flexibility.
Who can a company give share options to?
A company can grant options to any person, but share option plans are usually intended to reward and incentivise employees, directors and service providers.
What type of shares?
Options can be granted over ordinary shares, the same as the founders, or over a separate class of shares with restricted rights, for example, non-voting, restrictions on transfer, no rights of first refusal on the issue or transfer of shares. The shares may be subject to buy back if the employee leaves the company.
How do you determine which class to give?
There are no hard and fast rules. For example, the shares being non-voting might not be important if options can only be exercised on an exit or if a nominee holding arrangement is in place. While it might seem practicable from a companys perspective to restrict rights attaching to employees shares, the creation of a separate share class may cause other issues. There are rules around varying rights attaching to a share class, and it is important that you talk through all of this with your solicitor to work out what, on balance, is best for your company.
Are most share options subject to vesting and what does it mean?
Most share options are subject to vesting. That means that the option becomes exercisable over a period of time. For example, you are granted options over 10,000 shares vesting over four years with a one year cliff and the balance vesting monthly over the following three years. This means that you have to stay with the company for at least a year before you can exercise any options and get shares. After just one year you can subscribe for 2,500 shares. The remaining options continue to vest monthly over 36 months. After four years, if you are still with the company, all your options will have vested, and you can subscribe for all 10,000 shares.
There could be other vesting conditions apart from time such as reaching a certain milestone in product development or achieving a sales target.
How does a share option plan work and what should be in it?
While there are various arrangements and plan types, typically, there are rules of the plan and an employee who is granted options is given a certificate setting out the number of shares, strike or option price, and vesting conditions. A company should try to build in as much flexibility as possible when putting rules of a share option plan in place. A company can have more than one plan.
Some key points to consider are:
- How many shares can be issued under the plan?
- Who can get options?
- What class of shares?
- The option/strike price?
- How and when can options be exercised – how much time do people have to exercise options after they are vested?
- Will shares be held by a nominee?
What else should be covered?
It would also be important to set out clearly what happens if employees leave the company. Can they still exercise vested options and for how long? Different rules can apply in different circumstances, e.g., an employee who leaves could have six months to exercise any vested options, and if they are not exercised within the six months, they lapse. Typically any options that have not vested will lapse when the employee leaves. An option plan would usually set out what should happen to the options on a sale of the company perhaps vesting of options accelerates so that all options are exercisable before the sale is completed or they could be exchanged for equivalent options in the buyer. From the companys perspective, there should be as much flexibility as possible. Provisions should also be included to allow for changes in share capital such as a sub-division of shares or a reorganization like a merger or putting a holding company structure in place. The plan can also set out how it is to be administered by the company.
Are there cases when shares make more sense than share options?
There are – for example, if an employee has already been with you for some years and you had never put an option plan in place, it might be appropriate to issue the shares to them now. An advantage of giving options rather than shares, though, is that the person doesn’t have to pay for the shares until they know whether or not they are in the money (i.e., have value) and can be sold. Also, a lot of arrangements are put in place that allow for the cashless exercise of options on a company sale for example, if the strike price is 5 per share and the buyer is paying 20 per share, the buyer just pays the difference of 15 to the option holder.
Who holds the options?
An option is usually granted to the individual. However, a company may require that any shares issued upon exercise of options are issued to a nominee company, who would hold the shares on behalf of all employees. The company then just has to deal with one shareholder in terms of shareholder resolutions, waivers, etc., but the employees still have all the economic benefit in the shares.
Does it make sense for tech startups to have nominee companies?
It does, but time and cost may be a factor for a startup. The rules can allow for a nominee structure, but this would not have to be put in place until just before options are exercised, a time that may be more suitable for the company. The need for a nominee company also depends on the rules of the option plan. For example, if options are only exercisable on a trade sale or exit, then there would be no need to set up a nominee to hold shares.
When is a good time to start thinking of setting up a share option plan?
It can be good to have in place before taking on key hires and certainly by the time of the first significant funding round.