For companies that are raising capital, one key investor concern is the company’s ability to attract and retain talent to drive the company’s business forward and respond to challenges that arise along the way. This is a significant challenge for companies that are at an early growth stage, because they often do not have the resources to provide the compensation packages offered by more established businesses. One way that companies can offset this disadvantage and attract and retain top talent is through stock option plans. This article provides an overview of stock option plans and sets forth key considerations to keep in mind when designing them.
Capital Raising and Team Commitment
When evaluating an investment opportunity, investors consider whether a company will be able to implement its business plan and how quickly they will be able to do it. This determines investment risk as well as return. While business plan implementation depends on many factors, including the company’s business model, sector trends and macroeconomic conditions, a key consideration is the strength and commitment of the company’s team. If a company cannot attract and retain a strong and motivated team, the business plan will not be able to be implemented and expected revenues will either not be generated or take longer to produce than projected, which will cause the investor’s return to fall.
A key concern of investors is the ability of a company to attract and retain a team that can implement the company’s business plan.
Particularly for companies that are at early stage of growth, the search for talent is challenging. These companies often do not yet have real business traction, have business models that have not yet been validated by the market and have limited resources. This makes it difficult for companies to provide salaries and benefits that can match packages that are offered by more established companies.
Retaining top talent has become increasingly difficult because, as work as become increasingly digitalized, employees in many sectors have much broader work options. This increases the likelihood that an employee will come to work for a company, stay for a short period of time, and then leave. This is an important business as well as investment risk.
The loss of an employee can negatively impact a company beyond the particular value of the employee’s work contribution. It can also cause the disruption of broader, department-wide or firm-wide work chemistry and flow which can a significant amount of time to recreate.
Stock Option Plans
One way for companies, particularly at earlier growth stages, to attract talent, is through stock option plans. While stock option plans can be structured in different ways, their key economic features are that they represent the right of a person, subject to certain conditions, to purchase a certain number of shares of a company, at a certain price, at a certain point in time. In simpler terms, it is the right of a person to become a part owner of a business.
The structure of stock option plans is based on the tax laws of the jurisdiction where they are located. Two types of stock option plans are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs can only be issued to employees of the company and have beneficial tax treatment. NSOs can be issued to any party but do not carry beneficial tax treatment.
Key Stock Option Plan Issues
There are a number of issues to consider in connection with stock option plans.
Eligibility. The first issue to consider is who is eligible to participate in the plan. Options can be provided to members of the executive team or the entire team. Some firms also provide stock options to third parties, such as advisory firms, in lieu of cash payments for services provided.
There is no hard and fast rule regarding who should be eligible to participate in a stock option plan. Stock option allocation decisions are a function of: (i) the company’s core philosophy regarding employees and employee compensation; (ii) market standards; and (iii) the amount of resources a company has.
Plan Size. The next issue in designing a stock option plan is what the size of the plan should be. This means the percentage of the company’s shares that should be set aside for employees who participate in the plan. As companies often go through successive funding rounds, one approach is to increase the size of the plan as the company grows in size leading up to a target amount of, for example 20%, of the company’s shares.
Total plan size and ramping up to it depend on the company’s growth trajectory, the need to attract third party investment capital and the impact of dilution on the founders. Large option grants to employees at an early stage of the company’s growth have a large dilutive impact on the founders and may make it difficult to attract investors in the future. A balanced view of the reasonable economic interests of all key parties (founders, employees and investors) is required to maximize value creation. Each of these components should work together to create value for the others.
When creating a stock option plan, a balanced view of the reasonable economic interests of all key parties (founders, employees and investors) is required to maximize value creation.
Cliff Period. The next consideration in stock option plans is the cliff period. The cliff period is a period of time that an employee is required to work with a company before they are eligible to participate in a stock option plan. The purpose of the cliff period to ensure that the employee is a good match for the company and can be reasonably expected to carry out their role in the company over the course of, at a minimum, the entire vesting period. A one-year cliff period is common.
Vesting Period. The vesting period refers to the time over which an employee will have the right to purchase all of the shares granted to the employee in connection with the stock option plan. 4 years is a common vesting period.
Type of Vesting. Vesting can be structured in different ways. One type of vesting in a straight-line vesting where the total stock award vests in equal amount, such as 20% a year, over a 5-year period. Another approach is to stagger vesting so that the vesting is weighted toward the end of the vesting period. An example of this could be 10% the first year, 20% the second year, 30% the third year and 40% the fourth year. A staggered vesting structure provides greater incentive for employees to remain with the company for a longer period of time.
Exercise Period. Stock options typically must be exercised within a fixed period of time. 10 years is common.
Exercise Price. Stock option grants give plan participants the right to exercise the option to purchase shares of a company at a particular price. There are two key issues for companies to keep in mind when setting the exercise price.
The first issue is related to taxation. While generally the mere grant of a right to purchase shares in a company is not taxable, it can be taxable if the exercise price is below the fair market value of the shares. This poses a particular problem for private companies, and more so for companies at an early stage of growth, who may have not been valued. In this case, the company must establish the valuation of the company and individual share prices through a reasonable method recognized by the tax laws of the jurisdiction which governs the plan.
A second issue related to the exercise price is making sure that it is not set too high so that employees will have no incentive to purchase it. Again, carrying out a thorough valuation of the company is a good way to make sure that the price is set appropriately.
Exercise Period. The exercise refers to the period in time over which stock options can be exercised. While this period begins and is defined in accordance with the vesting schedule, a key issue is how long after employees leave the firm can it be exercised. It is typical that this be 90 days.
Clawback Right. Stock option plans typically set forth circumstances under which the company can cancel the employee’s options, such as if the employee is terminated for gross misconduct.
Legal and Tax Review
The granting of stock option plans has significant tax implications for both companies and employees. Given that the tax treatment can vary in different jurisdictions, it is important to structure the plan based on the advice of tax and legal counsel. Further, as employees have different tax and legal situations, they should likewise be encouraged to discuss plan terms and conditions with their own professional advisers.
Communicating Terms of Stock Option Agreements
Stock option plans are sophisticated financial arrangements and are based on legal documentation that likely will be unfamiliar to many plan participants. In order for stock option plans to be successful, it is recommended that companies implement an educational process explaining the terms and conditions of the plan in straightforward terms that can be easily understood and giving employees the right to ask questions and receive answers regarding plan-related issues.
Companies should also proactively advise employees of their vesting status, options that can be exercised at certain points in time and any important deadlines that will have an impact on the employee’s rights under the plan. This is necessary so employees are aware of their rights and obligations and can make informed decisions regarding their plan participation.
Conclusion
The search of capital is a competitive process and any steps that companies can take to lower investment risk increases the probability that an investment will be made. Stock options plans are an excellent way to attract top talent, incentivize long-term employee engagement and increase the probability that initiatives financed by investors will be successfully carried out.
Note. This article is meant to provide a general overview of stock option plans and not provide specific tax or legal advice. Any company contemplating designing a stock option plan should do so based on legal and tax advice in the jurisdiction where the plan will established.