Start-Ups and Securities - Understanding Stock Options
August 2022 - 6 min read
Stock options are a type of security granted by a corporation (the "Issuer") to a person (the "Optionee"), giving such Optionee the right, but not the obligation, to purchase an underlying security of the Issuer at a future date for a fixed price and on certain terms and conditions. Start-up companies grant stock options for various reasons, the most common of which is to attract and retain talent, advisors, or even directors. In addition to using stock options as part of an incentive package, stock options may also be granted as a form of compensation in lieu of cash payment, especially in the early stages of a company's lifecycle.
Typically, the terms of a stock option grant are outlined in an option agreement and corporate documents of the Issuer, such as the option plan, directors' resolutions, or even employment agreements. Most of the terms of the stock option grant, such as the vesting date/period, expiry date, exercise or strike price, and the number and type of underlying security issuable upon exercise of the stock options, are often fixed or tied to the occurrence of certain events.
This article assumes that the security underlying the stock options are common shares, and the focus is on stock options granted by start-ups or private corporations. The goal is to provide some insights and practical considerations to help both start-ups and Optionees better understand the workings of stock options.
Granting and Administering Stock Options
The following are some practical considerations for start-up companies as they grant and administer stock options:
- Eligibility for option grant – Stock options, like any other security, are governed by securities laws. To this end, ensuring applicable securities laws are complied with for each grant of stock options cannot be overemphasized. In Canada, for example, stock options should not be granted by a company unless they are qualified by a prospectus or an exemption from the prospectus requirements applies to the grant. Founders need to work with their legal advisors to ensure that potential Optionees are "eligible investors" under applicable securities laws at the time of grant.
- Exercise or strike price – Stock options are typically granted with an exercise or strike price of the current fair market value ("FMV") of the underlying common shares at the time of grant. As most start-ups expect to grow and have an increased valuation over time, the projection is that the value of the underlying common shares will increase with time. When the Optionee exercises the stock options, the Optionee would be at an advantage as the exercise price would be at a discount to the FMV of the underlying common shares at the time of exercise of the stock options. However, it is also possible that the FMV of the underlying common shares drops lower than the exercise price, so the Optionee will be at a loss if the stock option is exercised at that time. In this regard, it is prudent to ensure that no representation is made by the Issuer in the terms of the stock option grant as to what the future price of the underlying common shares might be. The Issuer should ensure the Optionees indicate in writing that they understand the risks associated with the stock options being granted.
- Option plans – Where a company seeks to issue stock options repeatedly as part of its incentive or compensation package, it is prudent to establish an option plan. That way the terms of the stock options are clearly stated, and it allows for uniformity and organized administration of grants. It should, however, be noted that having an option plan is not mandatory in all cases but is recommended.
- Dealing with outstanding options upon IPO or any other liquidity event – Most start-ups dream of being the next unicorn and/or growing to the point of being listed on a stock exchange. While the possibility of an initial public offering ("IPO") is usually further down the road for a start-up, it is recommended that founders turn their minds to how outstanding stock options will be dealt with in the event the company decides to go public or upon the occurrence of another liquidity event. This could be addressed in the option plan or in the option agreement entered into by the Issuer and the Optionee at the time of the grant. That way the Optionee understands what to expect at the occurrence of such an event from the get-go.
- Updating the capitalization table – In granting stock options, an Issuer is required to establish or reserve an option pool comprising the number of underlying common shares issuable upon exercise of the stock options granted. This option pool is usually documented in the capitalization table of the Issuer. It is important to keep track of the expiry date for each stock option granted so that the capitalization table can be updated accordingly.
- Applicability of a USA upon exercise – Where an Issuer has an existing unanimous shareholder agreement (the "USA") and the securities underlying the stock options are securities subject to the USA, it is imperative that potential Optionees are provided with a copy of the USA for review, and it is recommended that the Optionees obtain independent legal advice prior to the stock option grant. This is important because if the Optionees exercise the stock options down the road, they should be aware of the terms of the underlying security as outlined in the USA.
Takeaways for Optionees
For Optionees holding stock options of a start-up as employees, consultants etc., here are some important items to pay attention to:
- An Optionee is not automatically a shareholder – If a person is granted a stock option, such person is not a shareholder of the Issuer as a result of the stock option grant unless they already hold shares of the Issuer. Until the stock options vest and the Optionee exercises them, the Optionee has no shareholder rights such as the right to attend meetings or to receive dividends or distributions.
- Exercise is voluntary – The purpose of a stock option grant is to put the Optionee in an advantageous position to potentially purchase the underlying common shares at a discounted price during the term of the stock option. Optionees ought to be aware that exercising the stock options should be voluntary and at their discretion.
- Monitoring the vesting schedule and expiry date – Stock options are usually granted for a term hence Optionees should keep track of:
- the vesting date of their stock options, being the date the stock options become exercisable;
- the vesting schedule; and
- the expiry date of the stock options, so they can take advantage of the potential benefits of the option grant when necessary.
As an example, if an Optionee is granted an option to buy 10 shares of Company A at $1.00 per share and the vesting date is one year from the date of the grant, while the expiry date is two years from the date of the grant, the Optionee may choose to exercise some or all of the options if at any time between the vesting date and the expiry date, the share price of Company A's shares has increased above $1.00 per share. In this situation, the Optionee would only be paying $1.00 per share pursuant to the terms of the option grant. However, if the Optionee does not keep track of the vesting and expiry dates or fails to monitor the growth of the company, they may miss out on great opportunities.
- Change of control of the company, resignation, or employment termination – One major term of an option grant that may be easily overlooked by an employee holding stock options in a start-up company is how such stock options will be dealt with if the employee chooses to resign or if their employment is terminated. Some Issuers may indicate in the stock option terms that the stock options expire upon termination for just cause and/or must be exercised within a period from the date of resignation. Also, in the event of a change of control of the Issuer, the Issuer may have indicated in the stock option terms that the stock options will become exercisable immediately or that the acquirer will substitute the existing stock options with its own stock options on similar terms, etc. It is strongly recommended that the applicable sections in the employment contracts, USA, option plan or any other relevant documents are understood to avoid surprises and/or to allow the Optionee to prepare appropriately in the event of such occurrences.
- Tax liability – Participation in an option plan may subject the Optionee to certain tax liabilities. Optionees need to seek tax advice on the tax implications of exercising stock options and/or disposing of the underlying security.
Option grants have the potential of being mutually beneficial to the parties involved in that it is a great mechanism for start-ups to incentivize employees or free up cash by using stock options as part of the company's compensation package, while the Optionee is given the chance to share in the company's potential growth by paying a discounted price for the company's common shares upon exercise of the stock option. That said having a good structure for administering stock options and understanding the intricacies of issuing and holding stock options are important for the parties involved to maximize the benefits therein.