Stock Option Agreement: Main Terms and What to Look For

What is a Stock Option Agreement?

A stock option agreement refers to a contract between a company and an employee, independent contractor, or a consultant. Employers use it as a form of employee compensation. Both parties submit to operate within the terms, conditions, and restrictions stipulated in the agreement. The party receiving the stock options is a highly valued employee who will earn the right to exercise stock options. In addition, the employee will be given the right to purchase the stock options at a pre-determined price.

A stock option agreement outlines the employee's rights. The company is granted stock options, which often involves a vesting schedule and exercise price or strike price. Once the options vest, the employee can purchase the options at the strike price in hopes of making a profit if the company’s stock value has appreciated.

Main Terms of a Stock Option Agreement

The stock option agreement has specific terms you should know. The terms help determine the scope and extent of the contract. For example, most stock options often have the following terms.

Parties to the Agreement

The agreement first lays down parties to the contract. Often, the parties are the company issuing the stock options and the employee receiving the stock options. The contract may refer to the employee as the optionee and the company as the optionor.

Stock Option Shares

Another term is the amount of option shares. This refers to the shares in the company that the employee will have the right to buy in the future. In the agreement, the number of options the employee is being issued.

Exercise Price

Another term in the stock option agreement is the exercise price. This is often the price the optionee has the right to purchase the shares. The exercise price, or strike price, is the fair market value of the company’s stock at the time of issuance. The exercise price can also be set at a discount or a premium to the fair market value.

Total Exercise Price

A stock option agreement will also have a total exercise price outlined for the employee. If the employee were to buy all of the options, the employee would have to pay the total exercise price to the company.

Effective Date

Another common term in a stock option agreement is the effective date. This is often the period within which the option becomes effective. For example, the effective date may be that day when the optionee signs the stock option agreement.

Conditions to Exercise

The other important term is the condition to exercise. The clause clarifies the conditions that must be satisfied before the stock option can be effective. While the optionee's commercial objective often determines the conditions of exercise, they aren't necessary. For example, another condition can be the time in the form of a vesting schedule.

Expiry Date

The other critical term in a stock option agreement is the expiry date. This period is when the option holder may exercise. The stock option agreement often terminates on the expiry date.

When entering into a stock option agreement, the parties often discuss the expiry date. However, different circumstances may determine and affect the actualization of the expiry date.

Here's an article about the terms of the stock option agreement

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What Should I Look for in a Stock Option Agreement?

When signing a stock option agreement, it's important to consider certain issues. Here're some factors to consider in a stock option agreement.

• Number of Shares. You must have clarity about the number of shares you can purchase. Before signing a contract, you must consider what options will be on your table now and in the future. Most times, factors such as vesting often affect the number of shares one can purchase.
• Exercise Price. Another element an optionee should look out to in an agreement is the exercise price. The price is often on the offer letter and stock option agreement. Ensure that the employee stock option agreement clearly defines the exercise price.
• Vesting Schedule. The standard vesting period is around four years and a one-year cliff. If you depart before the cliff, it's important that you also understand the consequences. You must pay attention to the vesting schedule on the agreement before making that important decision.
• Early Exercise of Option. You must pay attention to the exercise option on the agreement. Check to ensure that the contract specifies the possibility of letting employees exercise vesting earlier. The tax benefits in such cases are beneficial to the employee.

Before signing the contract, these are some important things to consider in a stock option agreement.

Here's an article on what to look out for in a stock option agreement

Can I Negotiate my Stock Option Agreement ?

It's always advisable for employees to negotiate the stock options before signing the agreement. Most times, employees feel inadequate where negotiations about stocks and salary are concerned. However, you can arrange your stock option agreement before signing it.

When negotiating, consider a background review of all the dynamics around the offer. Conduct your research to ensure that you are knowledgeably informed about the key terms you can negotiate.

Here's an article about negotiating a stock option agreement

Examples of Stock Option Agreement

Different companies offer varying plans for stock options for their employees. Here are some of the well-known examples of stock option agreements.

Wordlogic Corporation, 2012 Equity Incentive Plan Stock Option Agreement

The agreement was more of an incentive plan for employees. Therefore, the contract had some of the essential terms discussed. They include the purpose of the plan, the definition, the grant date, the expiry date, and the participants.

The terms also include the qualifying performance criteria. Here, employees can read through and note areas that may disqualify them from the contract. The plan's administration and the options are the other critical elements stipulated in the agreement.

Here's an article about an example of the stock option agreement

How Do Employee Stock Option Plans Work?

The employee stock options refer to a plan that's offered to employees. The plan stipulates the options to buy shares of the company's stock at a certain price for a specified period. The program can act as a supplementary source of income for the employee.

Investing in ESPP is a great idea, given that it can help employees meet short-term financial objectives.

Incentive Stock Options vs. Non-Qualified Stock Options

There're notable differences between incentive stock options and non-qualified stock options. One significant difference is that incentive stock options are only eligible to employees. The recipient must also be a person, so it can't be issued to entities like contractors.

On the other hand, non-qualified stock options are open to both employees and independent contractors. These may also include non-employee directors.

Both options are not taxable when granted. But taxes apply when you sell your shares, based on the exercise price and the current value of the shares. This is an important note.

The options have varying treatments regarding taxation upon exercise for income. For example, in the case of ISOs, it's taxable for amount but not income or employment tax. On the other hand, NSOs are only taxable for tax purposes and never for AMT purposes.

For favorable tax treatment, there's an annual limit of stock for ISOs, which is $100,000 in stock options that can become exercisable in any one year for any individual employee. However, there is no limit for NSOs.

These are some of the most important elements that separate ISOs vs. NSOs.

Learn more about ISOs vs. NSOs.

Get Help with a Stock Option Agreement

When it's your first time handling the stock option agreement, it's important to have a legal mind in your corner. So take your time to understand all the terms and elements of the contract.

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