Stock Option Plans are an extremely popular method of attracting, motivating, and retaining employees, especially when the company is unable to pay high salaries. A Stock Option Plan gives the company the flexibility to award stock options to employees, officers, directors, advisors, and consultants, allowing these people to buy stock in the company when they exercise the option. Stock option plans permit employees to share in the company’s success without requiring a startup business to spend precious cash. In fact, Stock Option Plans can actually contribute capital to a company as employees pay the exercise price for their options. However, a company needs to address a number of key issues before adopting a Stock Option Plan and issuing options. Generally, the company wants to adopt a plan that gives it maximum flexibility.

“A company needs to address a number of key issues before adopting a Stock Option Plan and issuing options.” 

Here are some of the important considerations:

• Total Number of Shares. The stock option plan must reserve a maximum number of shares to be issued under the plan. This total number is generally based on what the board of directors believes is appropriate, but typically ranges from 5% to 20% of the company’s outstanding stock. Of course, not all options reserved for issuances have to be granted. Also, the investors in the company may have some contractual restrictions on the size of the option pool to prevent too much dilution.
• Number of Options Granted. There is no formula as to how many options a company will grant to a prospective employee. It’s all negotiable, although the company can set internal guidelines by job position within the company. And what is important is not the number of options, but what the number represents as a percentage of the fully diluted number of shares outstanding. For example, if you are awarded 100,000 options, but there are 100 million shares outstanding, that only represents 1/10 of 1% of the company. But if you are awarded 100,000 options and there are only 1 million shares outstanding, then that represents 10% of the company.
• Exercise Price. How much does the optionee have to pay for the stock when he or she exercises their option? Typically, the price is set at the stock’s fair market value at the time the option is granted. If the stock’s value goes up, the option becomes valuable because the optionee has the right to buy the stock at the cheaper price.
• Time to Exercise. How long does the optionee have the right to exercise the option? The Stock Option Agreement typically sets a date when the option must be exercised (the date is usually shortened on termination of employment or death). Most employees only have 30-90 days to exercise an option after their employment with the company has terminated. This can be burdensome, particularly since the optionee may not have been able to sell any of the underlying shares to help pay the tax resulting from the exercise of the option.
• Vesting. How do options vest? Most companies provide a vesting schedule, where the employee or advisor has to continue to work for the company for some period of time before the optionee’s rights vest. For example, an employee may be awarded options to acquire 10,000 shares with 25% vested after the first full year of employment, and then monthly vesting for the remaining shares over a 36-month vesting period.
• Consideration. The plan should give the board of directors maximum flexibility in determining how the exercise price can be paid, subject to compliance with applicable corporate law. So, for example, the consideration can include cash, deferred payment, promissory note, or stock. A “cashless” feature can be particularly attractive, where the optionee can use the buildup in the value of his or her option (the difference between the exercise price and the stock’s fair market value) as the currency to exercise the option.
• Illiquidity. Stock in privately held companies is typically not liquid and is difficult to sell.
• Cash Usually Needed. To exercise an option, the option holder typically has to pay cash out of pocket for the exercise (very few companies allow “cashless exercise”).
• Transferability Restrictions. What restrictions apply to the transfer of the option and underlying stock? Most Stock Option Agreements provide that the option is nontransferable. The agreements also state that the stock purchased by exercising the option may be subject to rights of purchase or rights of first refusal on any potential transfers. Increasingly, companies desire to implement more robust restrictions on both the options and the shares received upon exercise of the options to limit trades in the secondary market that may cause practical concerns in managing holders of the company’s stock.
• Right to Terminate Employment. To prevent giving employees an implied promise of employment, the plan should clearly state that the grant of stock options does not guarantee any employee a continued relationship with the company.
• Right of First Refusal. The plan (and related Stock Option Agreement) can also provide that in the event the option is exercised, the shareholder grants the company a right of first refusal on transfers of the underlying shares. Doing so allows the company to keep share ownership in the company to a limited group of shareholders.