Granting Options to Employees in Start-Up Companies

ספטמבר, 2021 / EKW

Introduction

Quality manpower is the basis on which successful companies are built. Certainly, the above is doubly true in cases of technology companies, whose main asset is an intangible asset in the form of intellectual property developed by the company's employees.

In this article we will try to explain in a nutshell the process of receiving the options on the part of the company employees, what is the significance of the standard mechanisms in options and what are the guiding considerations when deciding whether to exercise the options to shares.

Equity- based reward – background

For more than two decades, during the 1990s, the insight has begun to take root also in Israel that in order to recruit quality manpower for growth companies, the companies must grant their employees an equity-based reward based on success, in addition to the "regular" salary.

The goal is clear: to try to harness the employees' performance to the performance of the company. The more employees contribute to the company's success and its business, the more they will benefit from it in the form of an increase in the value of the company and the options they hold.

It is important to note that this has also found its way into other areas of the Israeli economy, and today companies engaged in traditional areas of practice also offer their employees equity-based reward in order to try to attract the good workers to join their ranks.

What is an option?

An option is a type of security for all intents and purposes. The option may be for the purchase of another security in the form of a share or bond in accordance with the conditions specified in the specific option and the option plan. In the case of allocating options to employees, the option is for purchasing company shares, and this is done in a process whereby the company (the company board of directors) must adopt an options plan, and then a specific option is signed for each of the relevant employees. Thus, the instructions applying to the employee in this context are specified both in the plan and in the option.

In parenthesis we will note that one of the main purposes of granting options to employees in an orderly manner is the taxable benefit embodied in the options plan in the form of capital and non-yielding tax payment, as well as deferring the tax event to the shares' date of sale after exercising the options.

Key instructions when receiving the options

The variety of provisions applicable to options can be divided into two types: provisions of a legal nature, alongside provisions of a commercial economic nature.

The first part, the legal part, may include trivial provisions that apply to any holder of a security with respect to obligations and rights derived from the mere receipt of the security in relation to the company and its organs.  Furthermore, there are additional legal provisions detailing the main rights conferred upon holders after the exercise of the options for shares (as a rule, these will be ordinary shares as opposed to shares with privileges granted to investors, in the form of preference shares).

The second part, the economic and commercial part, may include provisions relating to aspects such as the number of options, the rate of options out of the company's total share capital, the exercise price of the option, the vesting period, the acceleration period, and the period within which the options may be exercised in the event of termination of employment in the company.

It is worthwhile and important to dwell upon two main mechanisms:

The first, the vesting mechanism of the options is usually determined over a period of more than two years during which the employee must continue to work for the company for the options to be actually credited to the employee[1]. In most cases, an initial training period (cliff) of several months and sometimes even a year is set, during which the employee is not entitled to receive any of the options allotted to him/her, however, if he/she completes the above training period, the rate of the options out of all the options granted to him/her matures, and the rest of the options mature for him/her on a regular basis (monthly or quarterly) until the end of the vesting period.

The second mechanism one should dwell upon is the acceleration mechanism of the stock options – acceleration, according to which the duration of the vesting period of the options for stock may be shortened given significant events in the company's life, say its issuance or sale in an M&A transaction. The logic is clear and assumes that even if the employee has not yet completed the entire vesting period of the options issued to him but during this period the company's business prospered and it managed to make an offering to the public or sell it, then it makes sense that the same employee would enjoy the fruits of such success.

Exercising stock options – what is important to check

Upon the end of the vesting period, the employee may (certainly is not obligated) exercise the options he holds for shares. In this context, it is important to ascertain several things:

First, in most cases the employee is obligated to exercise the entire options he/she has for shares and not just part of them. Of course, the company's interest is trivial, and it does not want any entity to hold shares and options at the same time.

Second, it is important to make sure what the exercise price of an option is compared to the company's share price at that time, and this, in order to understand what the inherent benefit in each option (if any) is. It should be mentioned that in most cases these are private companies, so the value of the company, and as a result also the price of the share, is not public domain and the company is not happy to publish it. In addition, in light of the fact that the value of the company is determined solely in the various investment rounds, there is no certainty that the share price as determined in the previous investment round will also be a price in the future round, not to say that there is no certainty that the share price will not actually decrease in the following round (down round). It is important to note that as long as the employee continues to work for the company, this inner struggle is spared and he/she may always wait for the exercise of the stock options until the desired 'Exit', in order to know for certain what the value of the benefit actually is.

Another provision which is important to ascertain is what is the duration of time during which the employee, who has terminated his work in the company is obligated to exercise the options in his/her possession for the shares, since at the end of that period the options will expire. In most cases, this is a period of about three months, and senior employees are sometimes given an additional extension of several additional months.

Summary

On occasions, granting options to employees appears as a kind of moto, but behind it there are many significant conditions and provisions that must be examined in depth before receiving the options, and certainly before they are exercised for shares.

Most companies are aware of the complexity of things and offer employees assistance and information about the company and its securities, so that they may truly assess the nature of the benefit inherent in the options, as well as better understands the significant provisions regarding the options.

From the employees' point of view, it is important to note that the very receipt of capital reward is welcome, but the mechanisms inherent in capital reward and the legal and economic implications involved must be understood in depth.

 

For further information please contact:

Hanan Efraim, Adv.                         Tsippi Bengi, Adv.

Office: 03-691-6600                         Office: 03-691-6600

E-mail: hanan@ekw.co.ol              E-mail: tsippy@ekw.co.il

 

[1] A vesting period of two years also complies with the provisions of section 102 of the Income Tax Ordinance applicable to options for employees