Startup organizations general employ stock options as a method of incentivizing employees. This gives rise to numerous questions about what happens to an employee’s stock options when the company issuing the options is acquired by another company or the issuing company goes through a public offering.
This article addresses those two scenarios. We begin by explaining how stock options function, the advantages of stock options, and the results of acquisition or IPO.
How Do Stock Options Work?
Stock options grant the employee the right to purchase shares of stock at a given price. Normally, the price is the current or present value of a share of equity.
When granting stock options to employees, the options are generally restricted from transfer. This means that the employee must continue to hold them or transfer/sell them back to the company. Further, the stock becomes fully owned by the employee after a specified period or upon achievement of company milestones. This is known as “vesting”.
Most stock vesting schedules allow ownership of the stock to vest over a 3-4 year period, with the first vesting to take place 12 months after employment. The remainder of the stock vests on regular intervals. If the stock vests upon achieving milestones, the stock vests automatically upon verification of achieving those goals. Further, the stock option generally has a time limit for exercise. For example, the option may be required to be exercised within 10 years of grant or they are forfeited.
Whenever the stock option has vested, the employee can exercise the stock option and purchase the stock shares as the stated price. If the stock has not risen in value, the shares are worthless. It is likely the employee will not exercise the options.
Often an employee will not exercise the option. Rather, she will sell the option back to the company. The company will pay the difference between the market price and the exercise price. This saves the employee from having to come up with the money to exercise the option. Of course, the employee can always exercise the option by paying the purchase price. She may then continue to hold or sell the stock.
The option agreement may have included restrictions on the right to sell the underlying stock. This generally comes in the form of a right of first refusal for the company to repurchase the shares before anyone else can purchase the shares.
What are the Advantages of Granting Stock Options
Granting stock options provides a number of advantages to the employee and company. First, the company and employee do not have to report the stock option grant as compensation. Because the grant allows the employee to purchase stock at the present value, the stock does not have monetary value at the time of award. The stock becomes valuable as the value of the stock rises. This allows the employee to take advantage of future company grow, thus incentivizing her to work harder to achieve that growth. Also, the employee does not have to pay taxes on the value until she ultimately sells the stock. When she does sell her stock, her tax rate is the lower, long-term capital gain rate (20% or less) rather than the generally higher personal income tax rate. Further, this gain is not subject to Federal Insurance Contribution Act (FICA) taxes.
Stock Options when a Company is Acquired or Goes Public
As discussed, ownership of a stock option vests over a period of time. It is not uncommon for the company to be acquired by a strategic purchaser or go through a public offering while stock options are still outstanding. Generally, the stock option grant will address these scenarios. If the grant is silent on these matters, default state-law rules apply.
The general rule is that non-vested options vest immediately if the company is acquired or goes through an IPO. The company acquirer will generally require that all stock or option awards be cleared up before the sale. Further, the Securities and Exchange Commission (along with any listing exchanges and underwriters) will generally require the equity structure of the company to be cleaned up. This means converting all preferred shares and negotiating the purchase or exercise of all stock options.
If the stock options vest immediately, the company may also include provisions concerning the repurchase of the option. This saves the company from issuing stock upon exercise of the option.
LawTrades Knows Stock Options
Developing a stock option plan for employees requires a number of important considerations. When developing a stock option plan for your company, it is important to work with a legal professional who understands these plans. The equity lawyers at LawTrades are experts in matters of equity compensation. They can provide all of the advice and guidance necessary to establish an effective equity compensation plan.