Some of the most valuable assets for any company are its employees, key service providers, and advisors. This is particularly true for startups and emerging companies. A talented and dedicated team is essential to a company’s growth and scaling its operations. Yet, it can be hard to find and retain qualified employees, advisors and consultants. Established companies can typically offer more competitive salaries, generous benefit plans, perks and the promise of stability. In an integrated global economy where there is a worldwide competition for top talent, the reality is that startups and emerging companies need to be innovative, not just in their technology and services, but also in how they attract and retain talent.
One way startups and emerging companies can attract talent and incentivize employees, advisors and consultants (“Service Providers”) is by offering equity in the company. This is typically in the form of issuing shares or granting options to purchase shares in the future. By granting Service Providers equity in the business, organizations can ensure that the interests of these key stakeholders align with those of the company. This article will explore how startups and emerging companies can effectively use options to attract talent and scale.
What are Options?
An option grants the Service Provider the right to purchase shares at a predetermined price in the future. The assumption is that the company’s value will increase over time and that the Service Provider will be able to purchase shares at a significant discount at the time of exercise, or cash-out on a liquidity event such as the sale of the company. For a high-growth company, this offers Service Providers significant upside. Notably, as options are only a contractual right to purchase shares in the future, an optionee is not the same as a shareholder. Optionees do not have the rights or privileges of shareholders, such as the right to vote or receive dividends – until the optionee exercises the right to purchase shares.
Vested options are exercisable at the discretion of the Service Provider. Thus there is little downside to the optionee as the optionee may choose when or if it will exercise the options. Options also result in more favorable tax treatment for Service Providers when compared to issuing shares directly. This is because the Service Provider will generally only realize a taxable benefit in the year the options are exercised (assuming that the Service Provider is not paying fair market value for the shares). This ability to defer taxes may not apply in certain circumstances, such as where the entity issuing options is a non-Canadian controlled private corporation with consolidated group revenue of more than $500 million. The tax treatment of options is beyond the scope of this article and should be discussed with a tax advisor who has experience with options.
Stock Option Plan
Before issuing options, startups and emerging companies will generally put a Stock Option Plan (“SOP”) in place. SOPs are not required, but are recommended as they outline the rights and restrictions related to any issuance of options. A SOP is a policy document that outlines the terms and conditions of how a company will issue and manage the options it has granted. A SOP also outlines the rights and obligations of the optionee. It specifies what will happen to the options on the occurrence of a specific event, such as the sale of the company or the termination of the employment or engagement of a Service Provider. Typically, each optionee will enter into an option agreement with the company that will specify key terms associated with their options, such as the number of shares being awarded to the Service Provider, the exercise price the Service Provider will eventually pay for vested options and the vesting schedule.
Startups and emerging companies typically grant options to Service Providers based on a predetermined vesting schedule. This means that the options will not vest, and the Service Provider will conversely not have the right to exercise its options, until a predetermined event or events have occurred. This vesting schedule can be tied to years of service or the successful accomplishment of a milestone, such as securing a key client. If the vesting schedule is tied to years of service, a portion of the options may vest on each anniversary of the Service Provider’s start date. This will assist in incentivizing the Service Provider to remain with the company.
When devising a SOP, many factors need to be considered for the plan to be effective. Some key considerations are outlined below.
1. Optionee Selection
Careful consideration should be given when choosing which Service Providers should be granted options. For example, long-term key employees in management roles who can directly impact the growth and performance of the business are usually preferred over roles subject to high turnover.
2. Selecting the Option Pool
A SOP will specify the total number of shares and class of shares that may be allocated pursuant to the SOP. The size of the option pool is typically a percentage of the company’s cap table and is negotiated by the key shareholders of the company, including the founders, key investors or other significant shareholders. The bigger the pool, the more the dilution in ownership can occur for each shareholder. The company must balance the risk of dilution with the need to ensure that the option pool is large enough to attract key talent. Though option pools typically range between 5%-20% of the company’s cap table, stakeholders should determine the appropriate size based on the unique factors the organization faces. The size of the option pool will typically be “topped up” on future equity financing rounds.
3. Strike Price
The strike price (or exercise price) is the predetermined price that the optionee must pay for the shares underlying the options. The strike price is usually set at fair market value at the time of the option grant unless there is a desire to reward past service by allowing the strike price to be set at less than the current value. Early-stage companies may set the strike price at a nominal amount to reflect the fact that the company’s valuation is typically low.
4. Vesting Period
The vesting period is the length of time that an optionee must wait to be able to exercise their options. Typically, options are not immediately available to be sold, exercised or transferred. The vesting period should be carefully considered because it could seem unattainable if the period is too long. However, if it’s too short, the optionee may exercise their options and then leave the organization, defeating the intended retention goal. It is common for startups and emerging companies to set a four-year vesting period for their Service Providers with 25% of the options vesting after the first year with the balance vesting monthly, quarterly or annually in equal installments over the following three years. Companies looking to reward past work of current employees may consider having a portion of the options vest immediately.
5. Termination of the Service Provider
The SOP will stipulate when the options will expire. This option expiry date is when the Service Provider will no longer be able to exercise their options. There are certain instances under which the option expiry date will be brought forward, for example, if a Service Provider is no longer engaged by the company. What will happen on termination is usually dependent on the reasons surrounding the termination of the relationship. What is typical is that if the Service Provider’s relationship with the company is terminated for any reason other than cause, the Service Provider will have a limited period following termination to exercise their vested options (e.g., 30 days following termination). If a Service Provider is terminated for cause, then the Service Provider’s right to exercise any vested options usually terminates immediately. In either scenario, the Service Provider’s unvested options are typically canceled. Startups and emerging companies should also consider including the option to repurchase any shares held by the Service Provider following termination. There are numerous reasons for doing so, including the desire to limit the company’s ownership for those who have received “sweat equity” to only those actively involved in the business.
6. Triggering Events
The SOP should also address what will happen if certain defined triggering events are to occur. This could include the termination of the employment or engagement of the Service Provider, the sale or restructuring of the startup or emerging business or a going public transaction. In the context of a sale of the company, organizations may want to consider if all or a portion of the unvested options will automatically vest. In addition, the company should ensure that it can force the exercise and sale of any vested options at the time of the sale of the company as a potential purchaser may be unwilling to acquire the business if it cannot acquire all of the shares of the company. If the exercise of the options takes place concurrently with the sale of the company, the options could be subject to a cashless exercise that would allow the optionee to exercise its options without having to pay cash to cover the exercise price. This is achieved by decreasing the number of shares the optionee will receive by an amount equal to the exercise price that the optionee would have been required to pay for exercising its options.
Options offer startups and emerging companies a method to attract and retain one of their most critical assets. Although there is significant upside in using options, companies should carefully consider how they structure options and SOPs to ensure they limit their exposure to risk, the ambiguity of terms and avoid unintended consequences in terms of the alignment of the company and the optionee.