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.