Option Grant: A General Guide
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An option grant is a type of compensation offered by companies to their employees or directors. It gives the recipient the right but obligated, to purchase a specified number of shares of the company's stock at a predetermined price (called the " strike price ") within a set period. Option grants are typically used as an incentive for employees or directors to align their interests with those of the company's shareholders.
How Does an Option Grant Work?
When an employee receives an option grant, they can purchase a certain number of shares of the company's stock at the strike price. The strike price is set at the stock's current market price at the time of the grant. However, depending on the company’s discretion, the strike price can also be set higher or lower than the market price. Either way, the employee can purchase these shares at any time during the option period. The option period can vary depending on the company’s policies and the terms of the option grant.
Once the option period has expired, the employee can no longer purchase the shares. If the stock's market price has risen above the strike price, the employee can purchase the shares and sell them immediately for a profit. This is known as exercising the option. If the stock's market price is lower than the strike price, the employee may choose not to exercise the option and let it expire.
What are the Benefits of Option Grants for Employers?
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Attracting and Retaining Top Talent
Option grants are a powerful tool for retaining top talent in a competitive job market. By providing employees with a stake in the company's success, employers can incentivize them to work harder and stay with the company for longer.
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Cost-Effective
Option grants are a cost-effective way for companies to compensate employees compared to traditional salary increases or bonuses. However, it’s important to note option grants result in dilution of existing shareholders’ ownership of the company, but they can still be good incentive for employees.
The employee must purchase the stock, the cost to the company is limited to the administrative expenses associated with the grant.
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Aligning Incentives
Option grants align with the incentives of employees and shareholders, as employees benefit from the company's success and stock price.
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What are the Benefits of Option Grants for Employees?
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Potential for Wealth Creation
The most significant benefit of option grants for employees is the potential for wealth creation. If the company's stock price increases, employees who have exercised their options can sell their shares for a profit.
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Motivation
Option grants can give employees a sense of ownership in the company and motivate them to work harder and contribute to its success.
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Diversification
Option grants allow employees to diversify their investment portfolio and potentially reduce their risk. It’s important to remember option grants are tied to the company’s stock, so employees may not have full diversification unless they sell their shares.
What are the Drawbacks of Option Grants?
- Risk: The biggest drawback of option grants is the risk associated with stock ownership. The value of the stock may decrease, and employees could lose money.
- Complexity: Option grants can be complex and difficult to understand, particularly for employees unfamiliar with the stock market.
- Tax implications: The tax implications of option grants can be complex and may result in significant tax liability for employees who exercise their options, depending on the type of option and the employees’ tax situation..
What are the Essentials of an Option Grant?
- Grantee: The person or entity receiving the option.
- Grantor: The company or organization granting the option.
- Exercise Price : The price at which the grantee may purchase the underlying security (e.g. stock).
- Vesting Period: The period during which the grantee must meet certain conditions before they can exercise the option.
- Expiration Date: The date after which the option can no longer be exercised.
- Option Type: The type of option, either a non-qualified stock option (NSO) or an incentive stock option (ISO).
- Strike Price: The price at which the grantee may purchase the underlying security.
- Number of Shares: The number of shares subject to the option.
- Plan Document: A written document outlining the terms and conditions of the option grant.
Key Terms
- Strike Price: The price at which the holder can buy or sell the underlying stock.
- Exercise Date: The date on which the holder can exercise the option.
- Expiration Date: The date after which the option can no longer be exercised.
- Vesting: The process by which an employee gradually acquires the right to exercise their stock options.
- Option Type: This refers to the exercise right of the option holder. They can be either American-style or European-style. American-style options can be exercised before the expiration date, and European-style options can only be exercised on the expiration date.
Conclusion
Option grants are a type of employee compensation that allows employees to purchase company stock at a discounted price. While option grants have many benefits for employers and employees, they also come with risks and tax implications that should be carefully considered.
As with any compensation, it's important for both employers and employees to fully understand the terms and conditions of an option grant before deciding whether it's the right choice for them. ContractsCounsel will help you go through each section of options.
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Ramsey T.
My clients are often small and medium size technology companies, from the "idea" stage to clients who may have raised a round or three of capital and need to clean up a messy cap table. I help with all legal matters related to growth that keep founders up at night - hiring people, allocating equity, dealing with shareholders and investors, client negotiations and early litigation counseling (before you need a litigator). I've seen a lot, and because I run my own business, I understand the concerns that keep you up at night. I’ve been through, both on my own and through other clients, the “teething” pains that will inevitably arise as you scale-up – and I’m here to help you. I have over 20 years international experience devising and implementing robust corporate legal strategies and governance for large multinationals. I now focus on start-ups and early/medium stage technology companies to enable a sound legal foundation for your successful business operations. Many of my clients are international with US based holding companies or presences. My 17 years abroad helps me "translate" between different regimes and even enabling Civil and Common Law lawyers to come together. Regularly, I handle early stage financings including Convertible Notes, Seed and Series A/B financings; commercial and technology contracts; international transactions; tax; mergers and acquisitions.
"Great communication via multiple media; quick to respond once actual communication channel was open; did exactly what he said he would do (in this instance, quicker than he said that he would be able to); knowledgeable; personable"
Jo Ann J.
Jo Ann has been practicing for over 20 years, working primarily with high growth companies from inception through exit and all points in between. She is skilled in Mergers & Acquisitions, Contractual Agreements (including founders agreements, voting agreements, licensing agreements, terms of service, privacy policies, stockholder agreements, operating agreements, equity incentive plans, employment agreements, vendor agreements and other commercial agreements), Corporate Governance and Due Diligence.
"Jo Ann offered thorough, legal advice with a quick turnaround. Thank you!"
Amber M.
Amber Masters has 11 years of experience as a contracts attorney, helping small businesses with an array of agreements, such as purchase agreements, master service agreements, and employment contracts. She has an extensive background assisting health care providers through practice transitions including dentists, doctors, and other health care professionals. She is a highly rated and acclaimed estate planning attorney and personal finance expert, who has been featured on CNBC, NBC, and Yahoo Finance. She successfully launched and sold a fintech startup and can empathize with the issues small and mid-size businesses face. Licensed in Oklahoma and Arizona.
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Justin K.
I have been practicing law exclusively in the areas of business and real estate transactions since joining the profession in 2003. I began my career in the Corporate/Finance department of Sidley's Los Angeles office. I am presently a solo practitioner/freelancer, and service both business- and attorney-clients in those roles.
"Justin was great to work with, we hope to work with him again in future."
Scott S.
I have over 25 years' experience representing individual and company clients, large and small, in transactions such as mergers and acquisitions, private offerings of securities, commercial loans and commercial endeavors (supply contracts, manufacturing agreements, joint ventures, intellectual property licenses, etc.). My particular specialty is in complex and novel drafting.
"Scott was very kind, communicative and helpful. All was quick and simple."
David H.
Michigan licensed attorney. A compelling combination of technology, sourcing, sales, and legal experience. Over 20 years in technology positions negotiating technology engagements and contracts. General practice legal experience. Significant IT contracts experience (from IT sourcing/procurement) with the State of Michigan and Zimmer Biomet (Fortune 500). Excellent people, negotiation, and writing skills; keen eye for continuous improvement. Trusted business partner co-leading or supporting cross-functional integrated business/IT projects.
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Benjamin V.
My practice involves counseling businesses and individuals on a variety of contracts, such as business formation, technology/IP, real estate, leases, and even domestic relations agreements. Much of my practice is dedicated to litigation. As such, I approach contract and transactional work from a litigation perspective by advising clients of the risks involved in failing to develop proper contracts. It takes more than knowledge of the law to be a good lawyer. A good lawyer is honest and forthcoming with clients and has a counseling ethos. And, to me, a good lawyer stands in the shoes of the client when considering how to best serve that client. Whether my client is a business or an individual, I am passionate about helping my clients understand their rights, responsibilities, risks, and possibilities.
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Capital Gains Tax
Option Grant
Texas
What are the tax implications of exercising an option grant?
I recently received an option grant from my employer, which allows me to purchase company stock at a predetermined price. I am considering exercising the options, but I am unsure about the potential tax implications. I want to understand how exercising the options will affect my taxes, including any potential tax liabilities or benefits, and whether there are any specific rules or deadlines that I need to be aware of.
Darryl S.
This is a really complicated question that depends on a) the kind of options involved (Non-Qualified vs. Incentive Stock Options) , whether you hold or sell the stock you get after exercise. b) The difference between the exercise price (your buy price) and fair market value (sometimes hard to determine if not a publicly traded stock) and c) your tax rate and if you're subject to alternative minimum taxes (gain is usually capital gains taxed rather than ordinary income). This is also best discussed with your tax advisor, rather than a lawyer.
Employee Benefits
Option Grant
California
Can you explain the process and legal implications of an option grant for employees?
I recently joined a startup company and as part of my compensation package, I was offered an option grant. However, I am not familiar with how option grants work and what legal implications they may have. I would like to understand the process and any potential risks or benefits associated with accepting this option grant as an employee, so that I can make an informed decision about my compensation package.
Brian W.
While not exhaustive, this summary should provide some of the basics when it comes to an employee stock option grant at a startup. When an employee receives stock options, the employee receives the contractual right to purchase shares of company stock at a fixed strike price (e.g., the option to purchase 10k shares of the company's common stock at $1.00 per share - meaning the employee will ultimately have to pay $10,000 to purchase the shares). Options generally vest over 4 years with a 1-year "cliff" (meaning no options vest until 12 months after the vesting commencement date) and then monthly (or quarterly) thereafter. Options generally expire 90 days after an employee leaves the company and there are several ways that vesting may accelerate (e.g. upon sale, change of control, or other liquidity event). Depending on your level/seniority, some of these terms may be negotiable. It is important to ask about the company's capitalization to understand your "fully diluted" percentage ownership interest. You will want to know the number of options that have been authorized and granted under the plan and whether additional options will be granted in the future. Likewise, you will want to know the company's latest valuation from their most recent 409A report. If the company raises additional equity in the future, that will ultimately dilute (or reduce) your ownership stake. You will want to understand if the company plans to grant you additional options in the future as some employers grant additional options annually (e.g. around your anniversary date) while others do so on an ad-hoc basis or not at all. In terms of potential risks and benefits, if the company does well in the future and your options are still valid, you might earn some money down the road depending on the difference between your strike and sale prices. There are tax implications to consider depending on the type of option granted (Incentive Stock Options vs. Non-Qualified Options) and whether you exercise your option to purchase and hold your shares for a time in advance of a sale. Ultimately, you should treat any compensation derived from startup company options as an unexpected windfall. The reality for most startups is that options are never worth anything down the road.
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