Option agreements for Startups: what should you know?

Many Hitech Startups choose at a certain stage to provide their employees with options. The objective is to encourage such employees to create value for the company in the long term and to create a sense of belonging to the company. Currently, many companies from other fields adopt the options model.

What are options?

Options are contractual rights of the employee to receive shares in the company under certain conditions set forth in the option agreement between the employee and the company. In most cases the option agreement shall refer to the option plan, which provides for a general framework for the grant of options in the company, and to an escrow agreement, under which certain options and the shares thereunder are held by an escrow agent for a certain period of time. In some cases options are also granted to officers, consultants etc., who are not company employees.

Tips for option documents

The Option documents include several basic typical provisions, which the parties should well understand. Below I will try to bring the main parts of such provisions and explain them.

The series of shares subject to the options – usually ordinary shares in the company. Such shares are often subject to prerogatives of preferred shares in the company, which are typically issues to investors. The preferences relate to dividends, exit compensation etc.

The exercise price of the options – the price that the employee will be required to pay in order to be issued the shares in the company. Such price is based on an evaluation of the company at the time of the grant of the option, which evaluation may be conducted in a variety of methods. However, in many cases the price will be discounted in relation to the company’s value.

The vesting of the options – the conditions that have to be met in order for the employee to have the actual rights to exercise the option. Those include in most cases periods of time during which the employee will continue his employment with the company and sometimes performance criteria.

The options’ type taxwise – when subject to Israeli tax law, there are several paths under which the company may grant options. The customary path is the capital gains path under Section 102 of the Tax Ordinance. The practical implication of such path are that the tax event (i.e. the one for which tax will be paid) is deferred – the employee shall not be required to pay taxes upon grant of the option or issuance of the shares, rather only when selling the shares; and, further, the tax rate is reduced – the employee will only pay capital gains tax (i.e. material tax saving) in accordance with the balance between the price at which he sells the shares and the price at which he exercises the option. Such benefits are conditioned on the holding of the options and shares by an escrow agent such that the employee cannot transfer them for at least two years.

Approval and reporting to the Tax Authority – it is important not to issue any shares before having the option plan approved by the Tax Authority and prompt reporting of each issuance of options to the escrow agent.

Plan administration – this authority is usually given to the board and each issuance has to be approved by the board.

Waiver of rights – in most cases the employee shall be required to waive many of his rights with respect to the shares, such as rights to participate in the issuance or transfer of shares in the company. In addition, the employee will usually be required to give a power of attorney to a nominee of the board for the purpose of voting the shares. The reasoning is that the options are aimed to provide an economic incentive and not to change the manner in which the company is managed.

Exits – the sale of the company is the main event in which option holders in a startup can benefit from their options. The provisions handling such situations grant the board with broad authorities in order to prevent the employees from impairing an exit deal. In certain cases, options’ vesting is accelerated upon an exit event.

 

Options are a proper tool to provide employees and suppliers with incentive. However, this matter raises complex material and technical issues and thus before granting or receiving options, all implications, including the legal and financial ones, have to be carefully evaluated.

 

Hebrew version published with todays’ Insider (News, Home Page) – http://www.insider-news.co.il/category/%D7%90%D7%95%D7%A4%D7%A6%D7%99%D7%95%D7%AA-%D7%9C%D7%A2%D7%95%D7%91%D7%93%D7%99%D7%9D