Stock option plans are a popular way to attract, motivate, and keep employees, especially when the company cannot afford to pay high salaries. A Stock Option Plan allows a company to grant stock options to employees, officers, executives, consultants, and advisors, allowing these individuals to purchase stock in the company when the option is exercised.
Employees can participate in a company’s success through stock option plans without needing a startup to spend money. In fact, as employees pay the exercise price for their options, Stock Option Plans can actually contribute capital to a company.
The major drawback of Stock Option Plans is when workers exercise their stock options, other shareholders’ equity may be diluted. The main drawback of stock options in a private company for employees, when particularly in comparison to cash bonuses or higher compensation, is the lack of liquidity. The options will not be the equivalent of cash benefits till a company produces a public market for its stock, is purchased, or offers to buy the employees’ options or stock. And, if the corporation does not expand and its stock does not rise in value, the options may become worthless.
Stock options have made thousands of people millionaires, making them very attractive to employees. (In fact, stock options have made many Facebook employees millionaires.) Stock Option Plans have become a powerful motivator for employees to work for a company’s long-term success as a result of the stunning success of Tech Giants and the subsequent economic wealth of staff members who held stock options.
What is the procedure for exercising a stock option?
The following diagram illustrates how stock options are granted and practiced:
ABC Inc. hires John Smith as an employee.
ABC provides John with options to purchase 40,000 shares of ABC common stock at a price of 25 cents per share as part of his employment package.
The options have a four-year vesting period with a one-year cliff vesting, which means that John must work for ABC for one year before he can start exercising 10,000 of the opportunities, and afterwards he vests the remaining 30,000 options at a rate of 1/36 per month for the next 36 months.
If John leaves ABC or is dismissed well before end from his first year, he is out of luck.
After his options “vest” (become exercisable), he has the option to purchase the stock at 25 cents per share, even if the share price has risen significantly.
If he continues to work for ABC after four years, all 40,000 of his option shares will have vested.
ABC achieves success and goes public, with its stock trading at $20 per share.
John exercises his options and pays $10,000 for 40,000 shares (40,000 x 25 cents).
John then starts selling all 40,000 share capital for $800,000 (40,000 x the publicly traded price of $20 per share), making a $790,000 profit.
The key problems with stock options:
Before implementing a Stock Option Plan and issuing options, a company must address a number of critical issues. In general, a company wants to implement a strategy that allows it the most flexibility. Here are some key considerations:
The overall number of shares is The stock option plan must set a limit on the number of shares that can be issued under the plan. This total number is generally determined by the board of directors, but it usually range from 10% to 15% of the company’s outstanding stock, based on the stage of the company’s growth. Of course, not all issuance-reserved options must be granted. Furthermore, venture capital shareholders of the company may well have contractual size restrictions.
The number of options given to an employee. There is no formula for determining how several possibilities a company will give a prospective employee. Everything is negotiable, though the company can establish internal guidelines based on job role within the organization. What matters is not really the variety of options, but how the number reflects as a percentage of the total number of fully diluted shares outstanding. For example, if you are granted 100,000 options although there are 100 million shares outstanding, your stake in the company is only about one-tenth of one percent. However, if you are granted 100,000 options so there are only 900,000 outstanding shares, you will own 10% of the company.
Consideration. Subject to compliance with applicable corporate law, the plan should provide the board of directors with complete freedom in determining how the exercise price can be paid. As an example, cash, payment, debt instrument, or stock can all be used as consideration. A “cashless” feature, in which the optionee could use the buildup in the benefit of his or her possibility (the difference between the exercise price and the stock’s fair market value) as the exchange rate to exercise the option, can be particularly appealing.
Shareholder approval is required. In general, the plan should be approved by shareholders, both for securities law reasons and to ensure the company’s opportunity to offer tax-advantaged reward stock options.
