I’ve been offered stock options. What should I do before I accept them?
November 10, 2020
By: Colin A. Walker and Ryan M. Tharp
Previously, Ryan Tharp, of our Corporate Department, discussed the requirements for a business issuing stock options. He now addresses some important points from the perspective of a C-Level Executive who is being offered stock options.
Many companies use stock options or other types of equity incentives to incentivize key employees. Usually stock options are issued under a written plan and an option agreement that you will be asked to sign. Those documents contain important provisions that you need to understand before accepting the stock options. You may even have the opportunity to negotiate those provisions. This post discusses common provisions applicable to stock options and why they’re important to you.
- Incentive Options v. Non-Qualified Options. This is a tax consideration. If you qualify for incentive options (i.e., you’re an employee and the company’s followed the required steps), it’s generally better from a tax perspective to receive incentive options.
- Vesting. Companies usually grant options subject to vesting. Vesting means, essentially, that you have to give back any options and stock that are unvested on the date your employment ends. This is intended to incentivize you to stay with the company. Vesting usually happens over a period of time. A common vesting schedule is a four year term with a one year cliff. This means that no options vest for the first year, but after 12 months ¼ of the options vest. The remaining ¾ of the options vest monthly over 36 months. Sometimes vesting can be based on events – for example, if you’re in sales, your options may vest if you hit a sales revenue target for four consecutive quarters.
- Acceleration of Vesting. Let’s say you’ve been granted options subject to vesting on a four year term with a one year cliff. One year later, ¼ of the options are vested and ¾ are unvested, but then the company is acquired by a larger company. Generally your unvested options will be cancelled upon the sale, so it’s important to look for a provision that accelerates the vesting so that you get the benefit of the options you were granted.
- Exercising the Option. A stock option is a right to buy shares at a stated strike price. Unless the documents permit otherwise, you generally will have to pay cash to exercise the options, plus your shares may be subject to tax withholdings. Sometimes that is inconvenient, either because it requires you to pay a large sum or the timing is difficult.
- A cashless exercise is when you pay the strike price with the stock you just purchased. For example, assume you want to exercise an option for five shares, the strike price is $1/share, and the fair market value of the stock is $5/share. If you exercise and pay cash, you pay $5 and receive five shares worth $25. In a cashless exercise, you exercise the option for all shares, but you pay the $5 by returning one share to the company, so you end up with four shares worth $20. This can be an important provision if the strike price is large.
- If the company sells while you hold options, it’s often easier on everyone if the company merely pays you the amount you’d receive in the sale (if you actually exercised the option) less the total strike price. The math on this is like a cashless exercise, but the company doesn’t even bother issuing you stock – it just pays you a lump sum.
- Finally, you should understand when you can exercise your option. Sometimes you have a limited window, and if you miss it, you’re out of luck.
It’s important to understand how your stock options work. There are other important provisions in addition to those discussed above. If you’re not familiar with options, or you don’t understand a provision or its implications, competent counsel should be consulted.