Once a company comes to grips with the tax and securities aspects of its stock option plan (see the accompanying articles), then it faces numerous decisions regarding how to structure the plan. It must satisfy the goals of the company and its existing shareholders, on the one hand, yet provide incentive to the employees that it wants to retain and motivate on the other.
Number of shares covered.
One of the first decisions the company must make is to determine how many shares will be available through the options. There are many factors to be considered, such as the current and future holdings of the principals, the current number of employees, future employees, dilution of current ownership, as well as any future fund raising. Owners must always be aware that current Texas law requires a two-thirds majority vote for sales, mergers, liquidations, and other similar acts. Further, the issuance of any shares, whether voting or not, will dilute the value of the current ownership.
Plan administrators
The company must determine the identity of the plan administer, normally an executive committee. The company must also decide the amount of discretion to give the administrators, particularly in such areas as plan interpretation, rule making, and administrative determinations necessary to operate the plan.
Modification of Plan
The company must alsodecide who will have the right to amend, alter, suspend, or discontinue the plan, and what, if any amendments require shareholder approval.
Eligibility for options
One of the most important determinations is who will be eligible for participation. Will it be based on years of employment, position, salary, or some other criteria? Will the clerical and high turnover, lower skilled positions participate, if so what will be the criteria? A like decision must be made for the highly skilled, highly in demand employees, particularly recent hires. Can these criteria be waived, and if so, by whom?
If an employee can exercise an option and not immediately sell the shares, will the company require the employee to sign a shareholder agreement dealing with the disposition of the shares? If so, what will it cover – death, divorce, disability, termination of employment, and a desire to sell by the employee are typically covered. If the company decides to require such an agreement, then it must cover what happens when such event occurs. Who will buy the shares; who has the first option or right of first refusal; is the purchase mandatory or optional; how is the purchase price determined and paid, cash, terms, or some combination? How will the purchase price be funded?
Exercise or Strike Price
The company must determine the exercise or strike price of the option, in other words, how much will the employee pay for each share when the option is exercised.
Time of Exercise
Another decision for the company is when can the employee exercise the option. Will it be the occurrence of an event or will be upon the expiration of a period of time?
Number of options
Another decision involves determining the number of options each class of employee may earn or receive each year. The company must also determine if there is any limit on the total number of options each employee can earn. It is possible to limit the percentage of shares covered, as well as limiting the total available for all employees and for each employee. Many times in a privately held company, the total held by non-principals is kept under one-third and are non-voting shares. There are several reasons for this – one concerns control and another concerns economics. The control issue deals with the two-thirds majority requirement mentioned above. The economic concern is not only that of the current principals, but also that of the future underwriters of a public offering. The company must not put itself in a position where the number of shares that are subject to options that may be exercised at a public offering are so large that the underwriters cannot place them. This concern should be addressed with one or more underwriters to get a feel what the market currently will bear and what it might be (knowing that will be only “educated speculation”) at the time of any projected future offering.
How will the Options be earned and vesting considerations
Another decision deals with when and if the options are vested, that is will they survive the employee’s termination of employment. Another decision involves deciding the basis on which the option will be granted. For example, employees can be granted unvested options based on their individual performances. Additionally, they can also earn options based on the company’s performance. These determinations can be based solely on subjective evaluations by management, or they can be based on objective criteria such as a percentage increase in earnings, revenues, sales, book value, or any other benchmark desired by the company.
Exercise of Options
The company must determine if an employee will be free to exercise all its options at one time, or will it restrict the number or percentage of options that can be exercised at any given time. If the plan restricts the number that can be exercised at any time, then, in the event it goes public, it can prevent a “dumping” of shares and a depression of stock prices. Further, the company can provide for a staggering of either exercise or sale after exercise or a combination, based on years of employment after a public registration. This can serve to keep employees working toward increasing the value of the stock. The ability of all the key employees to exercise their options, cash out, and move on can have a detrimental impact on the value of the shares.
Term of Plan
Another decision involves the plan termination date. The company may want a plan with a short duration, one or two years, to be replaced with another plan at a later date. For example, the company’s needs may change dramatically after a public offering. Further, in the event of a sale or public offering, the company may want the plan to terminate to avoid creating a burden on the acquiring company or the public company, as the case may be. Further, the plan should give the plan administrators a great deal of flexibility to modify the plan as the company and its needs grow, change, and mature. It is possible to provide a plan with one year’s duration and then to either amend the earlier plan, restate it, or create a new plan, incorporating the best features of the prior plan with such modifications as are necessary to meet the new needs of the company. In any event, the options granted under each plan or successor plan would not be altered by the new plan.
Preemptive rights and cumulative voting
As an additional precaution, the company’s articles of incorporation should deny cumulative rights and prohibit preemptive voting. This prevents the diluting of the rights of the principals.
Type of shares
If the company decides to allow employees to exercise options while the company is privately held, then the company may want to amend its articles of incorporation to create a new class of nonvoting common shares which will be covered by the options. If the company decides to permit the options to be exercised only after a registration statement is on file, then the shares covered by the option will be those which can be publicly traded, presumably voting common shares.
Option coupled with restrictions
If the company wants to encourage the employees to continue to own their shares after the exercise, the shares can be restricted from being sold for a period of time. This means the employee must have the cash available to purchase the shares. All employees may not have such funds.
Effect of stock splits, etc.
A typical plan provides that the number of shares covered and the options granted, and the applicable exercise prices, are subject to equitable adjustment in the event of stock dividends, stock splits or similar reclassification. Further, the typical plan may provide that in the event of merger, consolidation, or reorganizations of the company, an appropriate substitution of the stock subject to options shall be made for the option.
Effect of Merger
The plan must address the disposition of the options if the company is sold for privately held stock or if there is a merger, consolidation, etc. Normally this is addressed in the merger or sales agreement by providing that the surviving company recognizes the options and enters into new option agreements covering a like amount of like shares in the surviving company. Please see the following articles for additional information: Employee Stock Option Plans, Tax Aspects of a Stock Option Plan, Federal Securities Aspects of a Stock Option Grant, Stock-based Compensation, Stock Appreciation Rights, Phantom Stock, Performance Units, Non-Qualified Deferred Compensation Plans, Texas Exemption for Employee Stock Option and Similar Plans.
THIS INFORMATIONAL MEMORANDA FROM THE LAW OFFICES OF THOMAS D. SOLOMON, P.C. is provided as a courtesy to our friends and clients to provide them with items of interest in the stock option area. It is not and is not intended to be an exhaustive treatment of its subject matter, but rather an overview of some of the pertinent elements of such matter. It is not intended to be legal advice or a legal opinion and should not be relied on in making legal or business decisions. If you have any questions, please call us.
