Background
Over the years, a number of mechanisms have taken root in an effort to ensure the retention of employees (of various grades) in business firms. Hence, in many technology companies, both veteran companies and startups, it is very common to grant employees various types of benefits, inter alia, options to acquire shares of the company.
The legal document which entrenches the conditions for employee stock options is a warrant, which is granted to an employee within the framework of an employee stock option plan (ESOP). The warrant contains the terms of the options, including the exercise price, the vesting period, the methods of exercising options, etc.
In the current article, we have chosen to describe a number of common corporate mechanisms specified within the framework of the warrants which detail the provisions of the options, the rights of the employee to exercise them, and the terms upon which he may do so.
The terms of the warrant
The class of the shares – In most cases, the options granted to employees are options to purchase ordinary shares in the company. There will often be various classes of shares in the company, such as preferred shares, which grant their owners (usually investors in the company) preferential rights over ordinary shares. It is important to point out, that in the event of a public offering of the company’s shares (IPO), issues of preferred share rights do not usually arise, since at this stage all the company’s shares are converted into ordinary shares, however the conversion ratio granted to the preferred shares may significantly dilute the employees’ shares. The most critical consequence from the employee’s perspective is that preferred shares may take priority in terms of the consideration which each share shall receive. In such a scenario, in the case of an exit, for example, preferred shares owners may receive most of the proceeds received from the exit, thus reducing the value of ordinary shares granted to employees by virtue of the options.
The option exercise price – One of the conditions anchored in the warrant is the exercise price of the option. In the case of a private company, there is no real ability to estimate the value of its shares, especially if the company has not yet raised capital through share allocation. After completing a number of investment rounds in the company, the value of the company can be determined and accordingly the value of the exercise of the stock options based upon the value of the company as determined when the last investment was raised in the company, with the expectation that the value of the company (and the share) shall increase, thereby embodying the benefit to employees.
In a public company which is traded on the stock exchange, the exercise price is usually determined by the share price when the options are granted. Thus, the employee may benefit from exercising options if the share price at such time is higher than it was when the options were granted. Conversely, should the share price have fallen by the exercise date, the employee shall obviously choose not to exercise the options.
The maturation mechanism – Shares cannot be purchased immediately upon receipt of the options but only upon expiry of the vesting period stipulated in the warrant and maturation of the options. The vesting period is normally 4 years spread over 16 consecutive quarters, and there is an initial training period of 24 months[1]. For example: An employee was given options to buy 40,000 ordinary shares in the company with a 4-year vesting period spread over 16 quarters. In the aforementioned example, in each quarter options to purchase 2,500 shares of the company shall mature and be released. Accordingly, after 30 months, options to purchase 25,000 shares shall have matured.
Another customary mechanism, particularly in relation to senior employees of the company, is the use of acceleration clauses, even where the vesting period has not yet expired in relation to some of the options it shall be accelerated so that all of them shall be deemed to have matured. Take for example, the case of an exit and IPO. Let’s say for instance that one and a half years after the start of the vesting period the company’s shareholders were to sell all their equity (an exit). If we follow the above example, on the face of it no options for purchasing shares have yet been released to the employee. However, in the case of an acceleration mechanism even none of the employee’s shares have yet matured there will be an acceleration of the vesting period so that all the options to purchase shares shall be regarded as having matured, thus enabling the employee to sell his entire share capital within the framework of the transaction.
Another scenario in which the vesting period is customarily accelerated is where a company decides to dismiss an employee from his position for certain predetermined reasons.
Conditions for exercising the option – As detailed above, at the end of the vesting period (of all or some of the options), the employee may exercise the options which have matured in accordance with the maturation mechanism as stated above, and purchase the shares for the strike price stipulated in the warrant.
However, in the event of termination of employment in the Company for any reason, such as dismissal (other than in an exceptional case where the employee is dismissed for a reason which disentitles him to severance pay) or resignation, or heaven forbid death or loss of working capacity, the employee may exercise those options which have matured prior to the termination date, for the exercise price stipulated in the warrant (and of course, there may be an acceleration in some cases where employment is terminated as aforesaid).
Power of attorney (proxy) – In most cases, the employee is required to sign a power of attorney (proxy) at the time of signing the warrant as a condition for granting the options. This is a power of attorney granted by the employee to a representative of the company, authorizing him to vote on behalf of the employee’s at a general meeting of the company. Accordingly, even after exercising the options and acquiring the shares, the employee cannot vote at general meetings of the company. This is a standard requirement of the company, the rationale for which, especially in the case of a private company, is obvious – the need to avoid having to deal with each shareholder who holds a small part of the company’s share capital.
Additional conditions – The warrant contains conditions in addition to those specified above, including a prohibition on the endorsement and/or transfer of the options to a third party, the subordination of the ESOP to section 102 of the Income Tax Ordinance (in order to enjoy the concessions granted within the framework of that section), etc.
It is important to note that the aforementioned conditions are the main conditions which are usually included in a warrant and there may of course be other cases which include additional conditions and/or mechanisms.
Conclusion
In certain cases, such as upon an exit or IPO, and of course in public companies traded on the stock exchange, the granting of stock options may constitute a significant benefit to the employee.
Therefore, and given the importance of the options, it is recommended that before signing a warrant, the employee should verify the conditions specified therein, including those mentioned above in this article and that the option satisfies the requirements prescribed in section 102 of the Income Tax Ordinance.
[1] A vesting period of 24 months is also consistent with the income tax requirements (section 102 of the Ordinance).