Tuesday, January 19, 2016

Issues to Consider When Offered Stock Options

It is commonplace for start-ups and emerging companies to offer stock option to employees, consultants and service providers in conjunction with, or often in lieu of, cash compensation. For the employee, consultant or service provider, the offer of stock options can be an opportunity to share in the potential success of the company, but a potential recipient of stock options should be aware of certain important considerations before simply accepting stock options in a start-up or emerging companies. This discussion summarizes key aspects of stock options and issues you should consider when negotiating terms relating to the possible grant of stock options in a privately-held company.

1.    Stock Options.

Before discussing the implications of receiving a grant of stock options as an employee or service provider, it is essential to understand the differences between stock options and other forms of equity  -- such as Restricted Stock and Warrants.  Stock options are issued to key employees, directors, and other service providers in exchange for services rendered to the company.  Options are a compensatory vehicle intended to increase the compensation of the recipient through an appreciation (hopefully) in the value of the company.  The recipient of the Options is given a right to acquire stock in the issuing company (the "issuer" or "grantor").  It differs from the actual grant of stock as the recipient (the "grantee", "optionee" or "option holder") does not actually acquire any stock in the issuer as a result of the grant, but only the right to acquire stock based on the terms and conditions set forth in the instrument granting the options.

The instrument granting the Option, often titled the Option Grant or Notice, provides the terms upon which the recipient of the Option has a right to actually acquire stock in the Issuer. The key components of any Option are as follows:

        • Date of Grant:  date upon which the grant is made to the Optionee
        • Type of Grant: Incentive Stock Options versus Non-Statutory Options
        • Number of Shares:  the number of shares that can be potentially be acquired by Optionee
        • Exercise Price:  the amount per share, if any, that the Optionee must pay to acquire the shares
        • Vesting Schedule:  the point(s) upon which all or a portion of the grant can be exercised          
        • Term:  the length of the options/expiration period, which is often 10 years

In addition, if an Option Plan has been adopted by the Company, the Notice of Option will state that the terms of the Plan are deemed incorporated in the Notice of Option.  The Plan (which may also cover other forms of equity grants authorized by the Company in addition to Options), will address important administrative and tax issues as well as issues relating to (i) the types of equity authorized for issuance, including the nature of the Options (Incentive Stock Options and Non-Statutory Options), (ii) the effect of the death, disability, termination for cause of the option holder, (iii) the right, if any, of the Company to clawback vested options upon certain events, (iv) the effect if a corporate restructuring or similar event; and (v) the treatment of grants upon a change-in-control or similar corporate transaction.   If the Issuer has not adopted a Plan, then these concepts should be addressed in the Option Grant or the Option Agreement -- which will also Option exercise procedure.

2.  How Restricted Stock and Warrants Differ from Options.

In contrast to Stock Options, Restricted Stock gives the grantee the right to purchase shares at fair market value or a discount, or at no cost.  While the grantee acquires the shares at the time of the grant (subject to payment of the purchase price, if any) the grantee cannot actually take possession of the stock until the specified restrictions lapse, otherwise referred to as vesting.  The vesting requirements can be based on the lapse of a period of time, the occurrence of a defined event or based on any other terms.  Even after the vesting occurs, the company may still have a right to repurchase the shares from the grantee upon the occurrence of specified events (such as termination of employment or a "for cause" event).  

Warrants are often confused with or seen as interchangeable with Stock Options, primarily because warrants have many of the features of Stock Options.  A Stock Warrant gives the recipient the right to acquire stock in the Company either immediately or at a future date at a specified price.  However, unlike options, warrants are not intended as compensation for services; instead, they are granted in the connection with a capital raise (equity or debt) as an added benefit to induce the investor/lender to provide the capital to the company.   Options and Warrants may look similar, but they have markedly different tax treatments, you should always consult a tax advisor, but in the simplest terms:
  • Upon the exercise of an option, the employee/service provider is taxed at ordinary income tax rates on the spread between the exercise price (i.e., price paid) and then fair market value of the stock on the date of exercise and ton a sale of the stock, the appreciation is taxed at capital gains rates;
  • There is no tax at the time of exercise of a warrant and only capital gains on the appreciation in the value of the stock
As a serious admonition, you cannot avoid the tax liabilities relating to options by simply labeling the grant as warrants.  If the grant is compensatory in nature, namely given to an employee or service provider as compensation for services, it will be deemed an Option and taxed accordingly.

3.  Key Considerations and Possible Terms to Negotiate When Offered Stock Options.

If you are offered stock options, do not just accept them until you fully understand the Option terms.   This means discuss the offer with a lawyer and your accountant so you understand the option terms and potential tax implications.   The company may argue that the terms are non-negotiable, but this is generally not the case for two reasons:  (i) even if the options are issued pursuant to a Plan, the company generally has the authority to set the option terms, is not required to offer all option holders the same terms, and can even deviate from the Plan as long the terms do not negatively affect other participants or create tax issues for the company, and (ii) if a Plan has not been adopted, the company may argue it is constraint by terms offered other option holders, but unless there is a contractual restriction or tax concern, the company has broad authority when setting the terms of the options.

The review of the option terms should the following topics.

           A.  Type of Options -- Are they Incentive Stock Options (ISOs) or Non-Statutory Options (NSOs).  ISOs can only be offered to employees/directors and non consultants and other service providers.  ISOs generally have a more favorable tax treatment since only the profit on the sale of the shares is taxed at capital gains rates the requisite holding periods are satisfied (as opposed to an NSOs, as to which the spread between the exercise price and fair market value on exercise is  taxed as ordinary income and any profit on a subsequent sale is then taxed again at capital gains rates). Again, there are nuances, including application of the AMT to ISOs, and thus the tax treatment of the grant should be reviewed with an accountant.

           B.  Amount of Shares -- The amount of shares offered can be stated as an exact number or as a percentage of the outstanding shares.  If the offer is for a specified percentage, there are two questions:  (i) as of what date is the percentage calculated -- the date of the grant or at the time of exercise, understanding that your ownership percentage will be diluted if additional shares are subsequently issued by the company; and (ii) how is the number of outstanding shares calculated -- if not on a fully-diluted basis (which would include the total potential option pool, warrants, convertible notes, other rights convertible into stock), then be prepared to be significantly diluted.

         C.  Vesting -- While for employees, vesting is usually tied to continued employment, with a portion often vesting upon hire and the remainder vesting over time (often 3 or 4 years), it can be based on on certain events or milestones.  For example, revenues, profit, growth in area of the business (such as number of customers, opening of new locations) and a wide-variety of other business metrics. If the vesting is based on continued employment, the terms should address issues with respect to temporary interruptions of employment, termination for reasons other than "cause," and  termination (by the employee) "for good reason".  If vesting is tied to conditions other than continued employment, the conditions should be clearly defined -- for example, how will "revenue"  or "profit" be calculated or what if the milestones are not met due to changes in company business strategy or policies.

       D.  Death and Disability -- The terms of any option grant should address how any unvested options are treated in the event of death or disability of the option holder.  A Plan or the grating instrument can state that the options terminate or that the company has the right to determine how they will be treated.  Of course, as the option holder, you would want accelerated vesting, but a partial vesting may be a way to compromise.

      E.  Change-in-Control -- What happens to unvested options if the company is sold?  In a word, it depends.  If there is an option plan, does it provide for acceleration of vesting and, if so, under what circumstances?  Is accelerated vesting left to the discretion of the company?  If there isn't a plan, then the granting instrument may or may not address the matter.  You may hear that there is a "Single Trigger" or "Double Trigger" acceleration, and you need to understand those terms and which one applies.   A Single Trigger means that unvested options automatically vest upon the change-in-control whereas a Double Trigger adds the requirement of a termination within a period of time after the change-in-control.  Other important issues include, to state a few, how is a "change-in-control" defined (f.e., not only sale of a controlling interest but also sale of all or substantially all of the assets of the company), what if the corporate transaction is a cash buy-out (and there is no surviving ore replacement stock in an acquisition) and there is a Double Trigger acceleration requirement, and what if there aren't specified terms addressing change-in-control or if acceleration is at the discretion of the company.

    F.  Term.  Most options have a ten-year term, but make sure it isn't a shorter period.

    G.  Right of First Refusal/Repurchase Rights --  The ultimate goal is that you will want to exercise the option (assuming the exercise is not simply in the course of a liquidity event, like an acquisition) and become a shareholder because the increase in the valuation of the company.  While you will not be a shareholder upon at the time of the grant, you need to be aware of any restrictions on the shares upon becoming a shareholder.  The rights and obligations of a shareholder in a company are usually set forth in a Shareholder's Agreement (or, they can be in the Plan document, Company's Certificate of Incorporation or in the Option Agreement).  Often the Company (and/or the shareholders) will have  a right of first refusal in the event a shareholder seeks to sell its shares to a third party. Separately, the Company may have a right to repurchase the shares upon termination of an employee-shareholder or of any shareholder upon the occurrence of certain events (such as death, divorce or a "for cause" event).  A Voting Agreement may also be a condition to becoming a shareholder.  The simple point is that due diligence is necessary before deciding to accept options as a component of the compensation.

Disclaimer:  The discussions in this Blog are for informational purposes and do not constitute legal advice nor create an attorney-client relationship.  You are urged to seek the advise of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.