Are you a founder or business owner thinking about how to attract and retain talent? Have you been offered options to join a company’s option plan?
We’ve prepared a quick guide to give some background on why we think they’re a great idea, explain some of the basic principles and set out how we at LawSimple can help.
What are options and what do they have to do with shares?
Options do what they say on the tin. The holder of the option receives the option (i.e. the right but not the obligation), to buy vested shares in a company at a future date and at a set price. If an option holder buys the vested shares, they are said to have “exercised” their option.
Only after the options have been exercised, will the option holder become a shareholder and receive associated rights to vote / receive dividends etc.
What are vested shares?
Share “vesting” is used to stagger an option holder’s ability to exercise options and receive shares. Vesting is usually linked to the amount of time the option holder (usually an employee) has served at the company that has granted the options.
The simple way to think about vesting is that it is analogous to ownership. You can’t do anything with a share until it has “vested”. If a share is “unvested” then you can’t exercise your option to buy it and you therefore can’t own it.
Typically an option grant will vest over 4 years with a 1 year “cliff” period. Below is a quick worked example to illustrate what this looks like.
Employee X is awarded 480 shares in Company Y which vest over 4 years with a 1 year “cliff” and monthly vesting thereafter.
(N.B. vesting after the cliff is not always monthly, it can be quarterly or annually and is something that parties often negotiate).
If Employee X leaves after 11 months then they will receive zero shares. Even though the award would suggest that Employee X has “earned” nearly 120 shares, the cliff operates to protect Company Y by removing any entitlement to shares until a minimum time has been served.
This makes sense: options are there to reward stakeholders that have worked hard and contributed to the long term success of a company. If an individual leaves before a year, then they shouldn’t be benefitting from upside that is generated over the following years.
If Employee X leaves after 38 months then they will no longer have to worry about the cliff. As Company Y has implemented monthly vesting then at the end of the 13th month, Employee X will be able to exercise options relating to 130 shares (i.e. the 120 shares that were “earned” in months 1-12 + the 10 shares that they became entitled to as a result of their 13th month of employment).
We should mention that option plans will contain lots of other terms that will govern how and when they can be exercised, including when they will “lapse” or no longer be capable of being exercised.
Why should employees be shareholders?
We think that employee share ownership is a no-brainer and that giving talent a share in the financial upside of a company’s success should be at the forefront of all founder’s plans.
This philosophy is deeply ingrained in the US (everyone has heard some version of the urban legend about the Silicon Valley masseuse who was paid in options and walked away a multi-millionaire), but Europe has traditionally lagged behind with employees favouring job security and higher salaries.
There are signs that this is beginning to change (albeit slowly), particularly in markets with a more developed VC scene (e.g. London), as founders, investors and employees recognise the tangible benefits that employee ownership can bring to an organisation.
One of the biggest obstacles to widespread adoption is that the tax treatment of options varies across Europe and is, in some jurisdictions (e.g. Germany), very inefficient. In Germany this has led to the development of alternatives know as “virtual options” or “phantom options”. You can read our post about virtual share option plans (VSOPs) here.
Why should I offer options if I am an employer (or accept them if I’m an employee)?
ATTRACTING TALENT
As a general rule, small companies (especially in the early days) can’t afford to pay large salaries.
Options allow start-ups to provide a tangible benefit in upside potential that they can’t provide in terms of short term cash.
Founders and employees should see options as part of the whole compensation package. If a company is not able to pay a potential employee a market salary for their role/experience then options represent a way of “topping up” the whole package to get to (or close to) what they could earn in the market.
2. RETAINING TALENT
As discussed above, options vest (i.e. become exercisable) over multiple years (typically 4).
Employees with options are therefore rewarded for staying longer. The more successful the company becomes the more the incentive to stay (or disincentive to leave if you’re as cynical as us).
Additional grants of options can also be used to reward high performers (and prevent them leaving).
3. MOTIVATING TALENT
Ask someone to work harder for the chance at a cash bonus that represents a small % of their annual compensation and they might just run the numbers and decide it’s not worth it.
This is particularly the case if they have no visibility on how much they might get and the metrics that are driving that decision.
Offer them a chance to have their efforts bring about a 20x return on their shares, then you have a different story.
4. TOTAL COMPANY ALIGNMENT
Founders are often remarkably driven individuals who are focused on building a company that will last.
By turning employees into “mini-founders” you incentivise the right behaviours.
Employees with options see the big picture and recognise that their interests are served not by squabbling with colleagues or competing for promotions, but in collaborating to make the company as successful as possible.
Do you have any more questions? Get in touch for a no-obligations discussion on how we might be able to help.
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