How stock options work, and how companies can draft a plan

Stock options and other equity incentives are a valuable tool for businesses to attract and retain talent by aligning their interests with the business’ growth and success. Stock option plans have become ubiquitous for cash-strapped startup companies seeking to conserve cash by supplementing lower salaries with potential equity rewards, while fostering a sense of ownership and commitment among employees. Properly structuring and administering the plan is crucial for compliance with securities, tax and other legal regulations and achieving the desired motivational effects.

In basic terms, a stock option grants an option recipient — typically an employee, director, advisor, or consultant — the right to buy a share of the issuing company at a pre-determined price in the future, referred to as the exercise price, before the option expires. A stock option is typically granted pursuant to the terms of a stock option plan, which governs the distribution of options from a pool of stock options managed by the granting company.

This article will explore current market standards for key terms that are prevalent in well-crafted stock option plans.

Key market terms

Vesting schedule

When issuing a stock option, the option recipient’s right to exercise the option will commonly be earned over time, based on a vesting schedule specified in the option grant. This vesting schedule specifies the amount of options that become vested (and therefore exercisable) at specific intervals, such as monthly, quarterly, or annually, or upon achievement of certain agreed milestones.

The current market standard or default for a vesting schedule is a four-year vesting period with a one-year cliff. This means the option recipient must continue to be employed or engaged with the company for at least one year in order to earn the right to exercise any options (i.e. the cliff) — typically 25 percent of the option grant. The remaining options then vest monthly or quarterly in equal proportions over the following three years. The vesting schedule will also often reference the employee’s start date with the company — a vesting commencement date — even though the option grant may not be formally approved until later.

This vesting schedule incentivizes employee retention and also prevents the inclusion of minority shareholders who joined the company but left within their first year.

Expiry, and what happens when an employee leaves

Options vest while an employee is working. If they leave the company, vesting stops immediately, and any unvested options are forfeited. The employee retains rights only to the options that have already vested before their termination date.

Upon departure from the company, the employee enters a post-termination exercise period, usually lasting 30 to 90 days. During this time they must decide whether to exercise their vested options by paying the exercise price to acquire the shares, which may require a significant cash outlay, or let the options expire. By staying with the company, employees can defer this decision and the associated cost, ideally until a more financially advantageous time such as participating in a secondary sale opportunity or a sale of the company.

Size of an option pool

The typical size of an option pool ranges from 10 percent to 20 percent of a company's total fully-diluted share capital. As the company grows and hires more employees, the option pool may need to increase to accommodate additional stock options. However, the company must carefully balance this increase with the impact of dilution on existing shareholders' equity.

An increase or top-up to the unallocated option pool frequently occurs in connection with equity financing transactions to ensure that there are enough shares available to attract and retain key employees after the investment. The increase will vary based on the circumstances, including the anticipated hiring needs for the business, and is usually expected to dilute only the existing shareholders and not the new investors participating in the financing.

Exercise price

The exercise price, also known as the strike price, is the fixed price per share at which an option holder can purchase stock when exercising their options in the future. Establishing the exercise price is important because it determines the option's value and its tax implications.

Generally, the exercise price of a stock option is set at the fair market value at the time of the option grant. This exercise price generally results in favorable tax treatment for Canadian-controlled private corporations and also incentivizes employees to focus on contributing to the company’s future value rather than enjoying an immediate discount.

In some cases, a below-market value exercise price for a stock option will be appropriate; however, careful consideration should be given to both the tax implications and business rationale associated with this.

Rights as a shareholder

For legal purposes, a holder of a stock option generally has fewer rights in respect of the underlying shares than a shareholder of the company. A company that wishes to establish a stock option plan or other equity incentive program should carefully consider what rights the holders of such equity incentives will have upon exercise of settlement for shares of the company. It is often advisable to limit those rights to a passive right to participate in the economic up-side of the equity, restricting or transferring any voting or information rights to the extent legally permissible.

The company may also consider including a right of first refusal or an option to repurchase the vested equity from the employee upon certain events such as a proposed transfer by the employee or their departure from the business.

Planning for the exit

A stock option plan should include provisions that protect the company during a liquidity event, such as a change of control acquisition or an initial public offering (IPO). Specifically, the plan should grant the board of directors broad authority to manage and settle options in a manner that is fair and reasonable at the time of a liquidity event. This ensures that the board of directors can pursue an exit without being hindered by small option holders who may otherwise block or delay a transaction.

How to draft a stock option plan

A well-drafted and properly administered stock option plan will support a company's growth by attracting talent, aligning employee interests with the company's long-term success, and carefully managing existing shareholder dilution and rights.

Managing various aspects of an option pool, such as vesting schedules, post-termination exercise periods, and rights as a shareholder upon exercise, can be complex and time-consuming. Fasken offers a solution for these challenges. As a Canadian leader in advising startups, Fasken has extensive experience and has drafted thousands of stock option plans to help companies succeed. If you wish to learn more, contact Ally Bharmal ([email protected]) or Geoff Pedlow ([email protected]).

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