Vesting and Exercising Options

Like most things when it comes to options, there is no rule you absolutely must follow when it comes to vesting schedules and the manor in which vested options are exercised. But before we dive in, let’s go over the difference between vested and unvested options.

Options will vest (i.e., become excercisable) over a period of time known as a vesting schedule. In other words, if an option has not yet vested, it cannot be exercised.

Creating a Vesting Schedule

When the board approves a grant of options to someone, the resolution approving the grant (or the grant document approved by the board) should set out the period of time over which the options will vest. Typically, there is a one year cliff, a full 12 months during which no options vest until the very end of that period. At that point, we usually see about 25% of the options granted vest. After that initial cliff, the usual approach is that the balance of the options vests on a monthly basis, in equal and consecutive tranches. The logic behind the cliff is that you don’t usually want someone who stays less than one year with your company to have the benefit of any equity.

Let’s put some numbers around this. Say you have 1,000 options which have been granted on day 1, and we want them to vest over a 4 year period (i.e., 48 months). After day 12 months, 250 options (i.e, 12/48ths) will have vested. And at the end of every month following month 12, 20.83 options (i.e., 1/48th) will vest.

But like I said, this isn’t a rule. If you want to have the options vest annually over 3 years, you could do that. If you want the options to vest every 6 months over 5 years, you could do that too.

Exercising Options

Option plans will vary on this point – some plans will allow an option to be exercised once they have vested, others will provide for a “double trigger”, i.e., the options must have vested and there must be a liquidity event.

Under the first scenario, you could have an option holder who has a small amount of options exercise those options, pay the exercise price, and get shares in exchange. That means you could have someone who has a very small amount of equity who all of a sudden has rights as a shareholder. So be careful if you go with this approach. Consult your lawyer, and make sure you have the right paperwork in place to protect the company. Keep in mind that shareholders have rights under the law.

Under the second scenario, the company has to usually be up for sale. Meaning, even vested options can’t be exercised until the sale is imminent. Here’s how this would typically work:

  • A buyer makes an offer to the company’s shareholders which they accept.
  • The board notifies the option holders of the impending sale.
  • The option holders then complete an exercise form and exercise any of their vested options.

Note that unvested options are usually cancelled and not part of the sale. If your company wants to allow unvested options to be sold, you’ll need a board resolution to do so. The board would say that the unvested options are “accelerated” and therefore all vested.

There are some nuances around cashless exercises of options, but that’s a technical point. In fact, you should check your option plan to see if it provides for it. If you’re wondering how that functions, consult your lawyer.

Granting Options

So you’ve got yourself an option plan with plenty of room in the option pool. So how do you go about making your first grant of options?

First things first. An option grant is not a gift (unlike the featured image above). And in fact, that’s a pretty good rule of thumb for anything relating to your company and the law generally – you can’t get something for nothing. There are exceptions, of course, but we won’t go into those here.

Now, on to the granting…

Eligibility Requirements

Start be checking your option plan, as it may have certain minimum requirements around to whom the options can be granted to. For example, some option plans require that options only be issued to people who qualify under the private issuer exemption of National Instrument 45-106. Other plans will let you grant options to consultants – but if you do that, your company loses its private issuer status, so be careful and consult a securities lawyer.

For the sake of simplicity, let’s assume your option plans allows you to issue options to directors, officers and employees of your company.

Number of Options to Grant

There is no hard and fast rule to follow here. The number of options you grant to any individual can vary. But keep in mind that options are, at least in part, a form of compensation. So for example, if you are paying certain employees below market (i.e. less than what they would be paid if they were working at another company), you may want to grant some options to them to make up the difference. But keep in mind that just because the company is worth $X today, it may be worth more or less tomorrow. So by its nature, granting options to someone involves some level of risk sharing.

If you’re looking for a simple rule of thumb, employees typically have anywhere from 0.1% to 1% of a company’s equity. It all depends on their role and contributions to helping make the company grow.

Exercise Price

If you retain anything, it should be the following – talk to your tax advisor before you go about setting the exercise price. Canadian tax and corporate laws can be strange beasts, and the exercise price of options is one of the most common problems that comes up.

The general rule is that options have to have an exercise price per option equal to the fair market value of the underlying share. But there can be exceptions, under certain circumstances. If you grant options with an exercise price below fair market value and you don’t meet the requirements to fall under the exceptions, you may have just caused a potentially massive tax liability for the employee who received the options. Be careful. Call your tax advisor.

And no, the price per share used in your last round of financing does not necessarily equal the fair market value at the time of grant today. So don’t think you can always rely on a valuation from 12-18 months ago for the today’s fair market value.

Paperwork

Now that you’ve got an eligible participant in your plan, you know how many options you plan to grant and you know the exercise price, you need to put some paper around this. Chances are that your option plan has a form of grant agreement or certificate attached to it as an exhibit. Use that!

There may be some additional fields to complete, like a vesting schedule for example. Option plans may provide for a default vesting schedule, while others may not. So keep an eye out for that.

And you’ll also want to put together a board resolution to go with the options grant. Investors love to see good record-keeping practices. Make sure there’s a paper trail showing that the board has approve the grant of the options and its terms.

What is an option pool?

What is an option pool, you ask? Yet another excellent question! (If you’re wondering what an option is, click here.) In this post, we’ll look at what an option pool is and how many options you should be allocating to the pool.

In search of a definition

Sometimes before you can define a term, it’s important to define what it is not. For example:

  • An option pool is a not a “person”, so you can’t issue or transfer options to the pool. (But it’s a common misconception.)
  • An option pool does not have any rights or obligations. But companies and option holders do!
  • An option pool is not a synonym for an option plan. (That’s the document which determines the size option pool, participant eligibility requirements, terms and conditions of grants and exercise, etc.

But on its most basic sense, an option pool is a term used to describe the number of options a company can issue pursuant to its option plan. It is composed of allocated and unallocated options, which can also be referred to as issued and unissued options, or granted and not granted options.

How many options go into an option pool?

There is no rule on how many options should go into an option pool. But when going about this, it is however important to keep some fundamental principle in mind, namely: the law of supply and demand, and market practice.

Supply

Supply will in part be dictated by how much dilution your shareholders are willing to suffer. Why are they being diluted? Well, options are usually exercised into common shares on a 1:1 basis, so each option you grant could one day be replaced by a new share. And if the company is sold, that means there’s less “pie” to share among the existing shareholders.

To think of it another way, let’s say you own 250,000 shares out of 1,000,000 shares issued. You therefore have 25% of the overall equity. Then the company adopts an option plan and reserves 111,111 options for allocation to eligible participants in the plan in its option pool. Assuming the options are exercisable on a 1:1 basis, that means you now have 250,000 out of 1,111,111 total securities. That’s 22.5% of the total equity, representing a dilutive impact of 2.5% on your equity stake in the company.

The trade off for the dilution is the presumption that the option holders are adding value and helping to grow your business. So although you may have 25% of a company when it is first incorporated, your company is presumably worth more then you start hiring employees and granting options. So keep in mind that 22.5% of something is better than 25% of nothing.

Demand

On the demand side of the equation, there is how many options your employees and new potential hires will expect to receive. And there is also the issue of how many options your investors will require you to set aside to make sure you can recruit top talent. The idea being that giving employees some “skin in the game” is a way to align their interests with the shareholders of the company.

What’s market?

Finally, there is the issue of market practice, or “what does everyone else do?” Typically, the number of options in an option pool will range from as low as 5% to as high as 20%. But it really depends on the company’s industry and its stage of development. 10% is usually a safe bet and option plans can usually be amended with relative ease to increase or decrease that number for the pool. But talking to your lawyer and your accountant in your local market is a great place to begin for reasonable comparables.

What is an Option?

If you’re reading this post, chances are that you are wondering about options. For example, you may be asking yourself: “What is an option? What is an option pool? How do you grant options? How do they vest? What does it mean to exercise an option?” All good questions. Let’s answer the first in this post and come back to the others later on.

An Option is a Security

In its most basic sense, an option is a security, like a share (but not identical). Options are securities which convert into, or can be exchanged for, other securities like shares. Another way to think of it is that an option grants the holder the right to acquire a share, subject to certain terms and conditions.

When dealing with options, this process of conversion or exchange is actually referred to as an “exercise”. There are some arcane reasons for the different names which we can skip. What you need to know is that options are securities, but they are not shares.

Securities Laws Apply

Why is that distinction relevant? Well, for one thing, knowing that an option is a security should make you ask another question: “Are options subject to securities legislation?” Yes, yes they are. Even options issued by private companies are subject to securities laws. So before you start issuing options to anyone, go call your lawyer (and put down that template you found online – chances are it won’t help you or save you any money).

Option Plans and Grant Documents

And knowing that they are not shares should tell you that options are not governed by a specific law (like the CBCA or the QBCA, for example). Options are instead governed by the option plan which created them and the option grant agreement or certificate which links them to an individual option holder.

An option plan is a document approved by a company’s board of directors which will typically set out the following basic parameters:

  • Who is eligible to hold options?
  • How many options can be issued under the plan?
  • Who decides who gets options and on what terms?
  • How are options exercised?
  • What happens is the company is sold?
  • What happens if the option holder is no longer involved with the company?

There’s more to it, naturally, but these are the generally speaking the most common issues which are addressed in option plans.

The grant agreement or certificate will usually state the following:

  • The name of the grantee
  • The number of options granted
  • Vesting terms and conditions
  • Exercise price
  • Date of grant and expiry

Grant documents also usually include a statement saying that the options granted are subject to the terms of the option plan.

Let the Experts Help

One of the great things about dealing with startups and emerging tech companies is that they are full of brilliant people. But sometimes, their bootstrapping habits are hard to kick and they try and do things on their own just to save a few bucks.

You wouldn’t issue shares on your own, would you? No.

So stick to the same rule with options, and let the experts help. Talk to your lawyer and your tax advisor before you do anything with options – there can be serious tax and other corporate consequences for both the company and the option holder if the plan and grants are not done correctly.

Board Meetings

If you’ve got a company in Canada, you’ve got a board of directors. So how do you run a proper board meeting?

Procedure

The first thing you should do is take a look at your corporate bylaws and, if you have one, shareholders agreement. Typically, the rules for calling and holding a board meeting will be clearly set out in those documents. For example, your bylaws might say that you need to send written notice of your board meeting at least 10 days in advance. So you want to make sure you at least get the procedures down pat so no one complains they didn’t have enough heads up for a meeting. (Believe it or not, it does happen.)

Setting the Agenda

Typically the chairperson of the board will prepare the agenda for the meeting. It’s one of the perks of being the chairperson – you get to decide what’s being discussed. For an average quarterly meeting, you might find items like updates on where the company is with its annual budget and business plan, discussions around entering into key agreements, strategic acquisitions or divestitures, planning for a pivot, etc.

Meeting Documents

Once the agenda has been set, you’ll want to assemble any relevant documents to be discussed at the meeting which relate to the items on the agenda. If there’s a summary of an important issue prepared by management, or a draft of an agreement, that should get packaged up along with any other relevant documentation.

Preparing and Sending the Notice

A notice of meeting is a short, one page document that simply advises directors of the date, time and place of the board meeting, and invites the directors to review the agenda and accompanying meeting documents.

Attach the agenda and meeting documents to your notice, and send those out to all directors in advance of your meeting. Be sure to double check your bylaws and shareholders agreement for the rules on sending notices electronically – sometimes it’s not allowed, other times it is, and even some others, a hard copy has to follow by snail mail.

There are also lots of different software and app solutions that can help you plan and prepare for a board meeting, and assist your company with broader corporate governance and record-keeping. More on those in another post!

Founders & Hats

The decision to go ahead and found a startup is an important one. And one of the first decisions you’ll have to make right after is who will make up the founding team and what hat each person is going to wear.

There are a variety of different roles. Generally across most legal systems, we find that a founder of a corporation can be a shareholder, director, officer and/or employee of a startup. At a more local level here in Montreal, this tends to be the case under both the CBCA and the QBCA. Other corporate entities like LLC’s from Delaware have “members” – which are similar to shareholders.

The size of the founding team is an important factor in deciding who will play what role. You may have 7 or 8 “founders” in the sense of “shareholder”, but do you necessarily wants 7 or 8 people to sit on the board? Perhaps not. Jeff Bezos said it best:

“If you can’t feed a team with two pizzas, it’s too large.” 

Jeff Bezos

Let’s take a look at the differences in roles:

Shareholders

Shareholders subscribe and pay for shares. Generally speaking, at the time of incorporation, the share subscription is for a nominal amount. Depending on the number of shares you issue, it could be as low as a few pennies per share.

Attached to shares are certain rights, for example, the right to vote, the right to dividends, and the right to the balance of any remaining assets in a wind-up. Let’s ignore dividends for now – if you’re starting up, you’re going to be reinvesting every spare penny you have. Let’s equally ignore wind-up scenarios – hopefully you’ll never have to worry about those.

Voting is how a shareholder expresses his voice to the other shareholders. The more shares you have with voting rights, the more weight your vote carries. If you own more than 50% of the voting rights, then you can generally say you “control” the corporation. But control is an ephemeral thing – don’t get too hung up on it, because you’re angels and VCs are going to demand veto rights on certain key decisions anyway. Nevertheless, control is still important, particularly before any money comes in, and it is what allows the shareholders to appoint the members of the board of directors.

Directors

Directors are long term thinkers who are concerned with the strategic direction of the business. They’ll meeting as often as is necessary (usually quarterly for big corporations, but more frequently in the case of startups). They also get to vote on certain key decisions, but the difference is that it’s one vote per director (unlike in the case of shareholders). Among these key decisions is the appointment of the officers of the corporation.

Officers

Officers manage the day-to-day affaires of the corporation. The basic titles are President, Secretary and Treasurer. The President looks after the operations of the business. The Secretary looks after the books and records. And the Treasurer looks after the finances. But startups tend to have cooler titles like CEO, CFO, COO, CTO, etc. Call it what you want – it’s the responsibilities that matter, not the titles.

Employees

We all know what employees are, and I won’t go into too much detail here because founders tend to take a special title and become officers of the corporation. But just know that a title is not required, and you can simply be an employee (but CTO does make for a cooler business card…).

What hat should you wear?

This really depends on what role you’ll have in the business. All founders are shareholders. So you can wear that hat.The main shareholders are also generally the directors (another hat!). Although there’s no hard and fast rule on this, practically speaking, if you’re a main shareholder, chances are you’re going to want a seat on the board. And you’ll also want that fancy title as an officer of the corporation (also comes with a new hat… Your head will be warm!). Just know that you don’t have to be a board member (or shareholder for that matter) to be an officer. And then you’ll hire the employees you need to get your project off the ground (in Montreal’s startup market, that means you’re likely hiring programmers – they have cool hats too).

Debt Financing

So you’ve got a friend or a relative, or maybe even an early stage third party seed investor who is ready to fork over a few grand to help you get your startup off the ground. The deal is simple: they give you cash, you promise to pay it back. What does it all mean?

This is what we call debt financing – but it can get a whole lot more complicated than a simple loan. In addition to a loan (which specifies an interest payment and repayment terms), debt financing usually takes the form of either a promissory note or a debenture. For the sake of keeping things simple, let’s exclude ordinary course debt like an operating line of credit or a company credit card. These are not good ways to finance your business! (Apologies for stating the obvious on this one.)

Promissory Notes

A promissory note is essentially a very simple loan agreement – and it does exactly what it says: Party A promises to pay Party B $X on or before date Y.

Debentures

A debenture is similar to a promissory note, but it will normally come from an investor with more sophisticated requirments. A debenture will contain certain restrictions on what you can and cannot do with the money (what we call the “use of funds”), and what important business transactions will require the consent of the investor. This is a way for the investor to keep an eye on management. If management goes ahead and does something that’s not permitted under the debenture, the terms of the debenture will usually permit the investor to call their investment back (plus penalties in some cases).

Convertible debt

Many of you have probably also heard of “convertible” debt, which usually takes the form of a convertible debenture. This “convertible” feature allows the investor and/or the company to convert the debt into equity if a certain event occurs (for example, a financing round, a sale of the shares or business, a new issuance of shares, etc.).

Food for thought

One thing to remember when financing your business through debt is that the investors become “creditors” of the company. In the event things go bad and the company goes bankrupt, they will rank ahead of the shareholders… You pay your creditors (debt holders) before you pay yourself (shareholders/founders).

Reverse Vesting

What is vesting? And how is it different from reverse vesting? Well I’m glad you asked!

Being a child of the 1980s and having grown up on Teenage Mutant Ninja Turtles, I quote the famous Casey Jones of TMNT fame: “You gotta know what a crumpet it to understand cricket.”

So before I explain vesting (i.e., cricket), let me take a moment to explain the difference between shares and options (i.e., crumpets). Shares represent an ownership interest in a company. Options are a right to acquire an ownership interest in a company.

Vesting is all about timing. It’s about the time at which someone can exercise a right. In the case of options, when an option has vested, the option holder can exercise their option and get shares in exchange for the option. This is a useful way to keep key personnel interested and involved in a company.

Shares issued to founders however are issued at the time of the organization of the company (usually right after it has been incorporated). So if the founders have already acquired their shares, how do you get them to “vest”? Well technically, you don’t. The workaround is called “reverse vesting”. Under this concept, 100% of the shares of the company are subject to a repurchase right at a nominal price in favour of the company (i.e., the company can buy back the shares for cancellation for pennies). The number of shares subject to this repurchase right is reduced over time.

If you take a look at the chart above, it shows you what a vesting schedule looks like over a 4 year period, with a 1 year cliff (i.e., 25% of the shares become “unrestricted” after one year). Each month thereafter, 2.083% of the shares held by the founder also become unrestricted shares, until 100% become unrestricted by the end of the 4 year period.

Given the high turnover in the initial stages of a startup, vesting or reverse vesting can be a useful tool in ensuring that those who are receiving equity early on stick with the business over the long term. And by the way, your investors will very likely demand it (and some may even reset vesting periods, depending on the timing and the size of the investment).

But be careful. There are not only corporate law considerations, but employment and tax issues that come up as well. Talk to your lawyer – this is important to get right.

Of Terms and Sheets

A few thoughts on term sheets:

There are lots of “standardized” term sheets out there designed to streamline the startup financing process. The problem is most of them are drafted in the US with US legal considerations in mind. Watch out for those… If you see the word “stock” as opposed to “shares”, chances are it’s a US-based model.

MaRS has developed a term sheet template for startups in Ontario, but take a quick look and you’ll note that this is all about preferred shares, not common shares. It’s definitely useful, but depending on the size of the seed round, preferred shares might not be right for your startup. In many cases actually, the first money is coming in the form common equity, which is identical to what the founders are issued following incorporation. Don’t get stuck in the trap of thinking that you MUST issue preferred equity to your investors. This is a myth.

Something you should be weary of when looking at a term sheet is focusing on the valuation, the dilution and the amount of the investment. Those are important, but don’t forget to read the rest of the term sheet!! There are clauses in there that you can negotiate if they are off-market. How do you know what’s off-market? You don’t. Someone who sees lots of term sheets however will. So don’t be shy – go out there and get some independent advice from your lawyer before you sign the term sheet. And remember, there is no such thing as a dumb question.