How do Stock Options Work?
We often get questions about stock options. Here’s a primer on what stock options are and how they work.
What is a Stock Option?
Stock options give you the right to purchase shares in a company at a set price in the future. This price is called the exercise price or the “Strike Price”. The benefit is that this set price stays the same despite the value of the company (and therefore its shares) increasing over time.
As an example, company X may grant you 100 stock options, giving you the right to purchase 100 Common shares in company X at the price of $1 per share. Whenever you decide to actually purchase the Common shares, this is called “exercising” your stock options.
Stock options are granted by the company to the option holder by contract. Often, this is done through a specific contract called an “Option Agreement”. However, stock options could also be granted in an employment contract or any other type of contract between the company and the option holder.
Why do Companies Offer Stock Options?
Here’s a couple of reasons:
to motivate employees by giving them an opportunity to participate in the ownership of the company; and
to attract employees if your company may not be able to match higher salaries offered elsewhere.
Why do Companies have Stock Option Plans?
In short, it’s because it makes the administration of stock options easier. Here’s a couple reasons to illustrate why:
Cap Table – By having a stock option plan setting the maximum number of shares that are reserved for the stock option pool, the company knows the potential impact of the stock option issuances on its cap table.
One Place for Detailed Terms and Conditions - The stock option plan is document that sets out detailed rules with respect to the company’s stock options. Think of it like a rulebook for how the company administers its stock options. For example, it will typically provide answers to questions such as:
How many total shares are reserved under the stock option plan?
What happens to the stock options if the option holder dies?
What if the company goes public?
When do stock options expire?
By having a stock option plan, the company doesn’t have to insert all of its terms and conditions into each contract in which it grants options to someone. This is because the grant will be subject to the terms and conditions of the stock option plan.
Why don’t Companies just issue Shares instead of granting Stock Options?
Here’s a few reasons:
No Immediate Cost – A person doesn’t have to pay anything in order to be granted stock options by the company. In contrast, shares must be fully paid for up-front in order to be issued to someone.
No Shareholder Rights – Holders of stock options are not shareholders in the company (assuming the holder has not exercised any of the options). In other words, having stock options by itself does not entitle the holder to any rights that a shareholder of a company would have (e.g., voting rights, dividend rights, liquidation rights). This means that the company doesn’t have to get the option holder’s consent for corporate actions that it otherwise would if the company issued shares.
Vesting
Stock options can be subject to vesting schedules just like shares. Stock options cannot be exercised until they are vested.
A standard vesting schedule is 4 years with a 1 year cliff. This means: (a) no stock options vest during the first year after the grant; (b) on the 1 year anniversary of the grant, 25% of the stock options vest and can be exercised; and (c) the remainder of the stock options vest in equal monthly increments on the last day of each month for the remaining 3 years.
Expiration
Stock options are typically set to expire at a certain point in time. You cannot exercise stock options after they expire – they are reverted to the company. The expiry date will depend on the stock option agreement and the stock option plan. In the event that you don’t set an expiry date in the stock option agreement, the stock option plan will typically have a default expiry date set for all options (e.g., 10 years from grant).
Other FAQs
What Strike Price do I use?
Typically, it’s to be the fair market value (“FMV”) of the related shares as of the date of grant. However, the board of directors can determine the Strike Price at whatever price it wishes. It could be a nominal price (e.g., $0.0001). Note that the option holder may receive a taxable benefit for the difference between the Strike Price and FMV of the shares on the date of exercise, so you may want to check in with your tax advisor on this.
How are Stock Options Taxed?
Stock options for employees and contractors are taxed differently. For employees, stock options are generally taxed when exercised. Employee stocks have the benefit of being taxed as capital gains. For contractors, stock options are taxed when they are granted. Contractor stock options are treated as income at the FMV of the shares. There is no tax deduction for companies who issue stock options.
What is the “Certificate Number” on the Option Agreement?
This is an internal tracking system to track the number of option agreements entered into by the company. For example, if the company is entering into the very first option agreement with an option holder, you’d simply write “1” for the Certificate Number.
What is the “Award Date”?
The “Award Date” should be the date you grant the options.
How many stock options should I grant to my employees / advisors?
There is no exact formula here. This will depend on their position, experience, how much value they provide, and how much other compensation they receive. Consult your lawyer or advisors for guidance for your particular situation. They should be familiar with market benchmarks to help make these decisions.
Who is the administrator of the Stock Option Plan?
Usually this is the board of directors, or any person appointed by the board of directors to manage the option plan on their behalf.
What percent of shares should I reserve for the Stock Option Plan?
Typically, companies reserve between 10% - 20%, depending on their stage and needs. You don’t need to use all of these reserved shares, and you can increase or decrease the number very easily at any point in the future. This option pool is simply reserved in the event that you wish to make grants in the future. The shares reserved are not actually issued by the Company until the related options have been granted, have vested, and have been exercised and paid for.
Ink LLP is a business law firm that acts as strategic counsel to ambitious entrepreneurs, investors, and high-growth companies. Contact one of our lawyers to discuss your business and how our team might be able to help you tackle the challenges of your business and the opportunities for growth.
This information is provided for informational purposes only and is not legal advice.