Stock options are a type of compensation that can help incentivize employees to join a company and/or remain with a company for a designated period of time. In order to operate effectively as incentive compensation, however, the stock option agreement must be executed well, to protect both the needs of the employer and the employee. Even when offered by an early-stage startup, stock options must be carefully drafted (and relate to an underlying and properly approved equity compensation plan) in place before offering employee stock options. If you are considering issuing stock options, a Priori employee benefits lawyer can help.
About Stock Option Agreements
Stock options are a means to both attract good talent and keep those employees invested in the company over time. Accordingly, in general, stock option agreements are offered to key employees in conjunction with the employee’s initial hire or concurrent with a significant increase in the employee’s role or responsibilities at the company. When a company offers employees stock options, they do so through a special contract called a stock option agreement. Such an option, once granted to the employee, gives the employee the opportunity to benefit from increases in the company’s share value by granting the right to buy shares at a future point in time at a price equal to the fair market value of such shares at the time of the grant. The option agreement dictates all the terms of the offer -- including vesting schedule, time limits for exercise once vested and any other special conditions.
Breaking Down the Stock Option Agreement
The following are some of the key documents and provisions involved in granting stock options:
Generally, stock option agreements consist of four key documents.
Stock Option Plan. The governing document for the company’s issuance of stock options, a stock option plan generally contains the terms and conditions of the options to be granted, including the purchase price and any limitations. Generally, it is a standard document for all options issued to employees at the same time.
Individual Stock Option Agreement. This is the custom contract executed by the company and any particular optionee. This document specifies the number of options the employee is entitled to exercise, types of options granted, the vesting schedule and other employee-specific terms of issuance.
Exercise Agreement. This document details the terms under which options can be exercised by employees.
Notice of Stock Option Grant. While not always included, a notice of stock option grant is generally included in the stock option agreement, as well. This document includes a short summary of the material terms of the grant. It generally serves to fulfill SEC notice requirements, and in some cases includes disclosures.
Key Terms and Provisions
Some key terms and provisions of stock options are as follows:
Grant Date. The date on which an employer grants an employee the option to buy a set number of shares at a specific exercise price.
Exercise or Strike Price. The price at which the employee can buy stock during the exercise period. The price must considered fair market value, but there are a range price can be calculated -- including by looking to the closing stock price (for public companies) and formal valuations (for privately held companies).
Expiration Date. The date on which the exercise period ends. Thereafter, the option is no longer available to the employee.
Exercise Date. The date an employee purchases stock pursuant to the stock option agreement.
Vesting Period. Generally, stock options are not immediately exercisable by an employee. Rather, there is a vesting schedule pursuant to which portions of the stock option vests over time -- often over a period of years.
Cliff. A specific interval of time during the vesting period before any shares are available. For example, a common pattern is that no shares vest during the first year following the option grant. After this “cliff,” some portion of the option typically vests on a monthly or quarterly basis.
Clawback Provisions. These provisions list the conditions under which the employer can take back (“claw back”) the part of the option that has not been exercised as of the date of a triggering event. Generally, this provision includes corporate events, for example, a bankruptcy, as well as employee-related event, for example, a termination.
Stock Option Contracts & SEC Compliance
All contracts issuing stock options must be compliant with SEC securities regulations. This means that all provisions of the option agreement must be compliant, and securities issued must be properly registered where applicable. In addition, employees issued stock must have the same disclosures and notices available to any other investor. Accordingly, it’s generally considered critical to consult an experienced lawyer before issuing stock options.
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What is a reasonable vesting schedule for a stock option agreement?
Reasonableness is, obviously, context-specific -- and generally depends on, among other things, the company’s stage of development and the negotiation dynamic with the individual employee and other related factors. For startups, four- or five-year vesting schedules have become standard. These vesting schedules often include a one- or two-year cliff.