Stock Option Plans permit employees to share in the company's success without requiring a start-up 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.
The primary disadvantage of Stock Option Plans for the company is the possible dilution of other shareholders' equity when employees exercise the stock options. For employees, the main disadvantage of stock options in a private company—compared to cash bonuses or greater compensation—is the lack of liquidity. Until the company creates a public market for its stock or is acquired, the options will not be the equivalent of cash benefits. And, if the company does not grow bigger and its stock does not become more valuable, the options may ultimately prove to be worthless.
Thousands of people have become millionaires through stock options, making these options very appealing to employees. (Indeed, Microsoft has reportedly made over 1,000 employees into millionaires from stock options.) The spectacular successes of Silicon Valley companies and the resulting economic riches of employees who held stock options have made Stock Option Plans a powerful motivational tool for employees to work for the company's long-term success.
A company needs to adddress a number of issues before adopting a Stock Option Plan and issuing options. generally, the company wants to adopt a plan that gives it maximum flexibility. 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 percent to 20 percent of the company's outstanding stock. Of course, not all options reserved for issuances have to be granted.
- Plan administration: Although most plans appoint the board of directors as administrator, the plan should also allow the board to delegate responsibilities to a committee. The board or the committee should have broad discretion as to the optionees, the types of options granted, and other terms.
- Vesting: Most plans allow the company to impose "vesting" periods for the options—for example, the options don't become exercisable unless the employee continues to be employed with the company. The board or committee typically has broad latitude to determine appropriate vesting schedules and even waive vesting. Typically, companies set the vesting period between three and five years with a pro rata percentage vesting either each month or year that the optionee maintains his or her relationship with the company. For example, an employee might be awarded options to acquire 30,000 shares, vesting in three equal annual installments so long as the company still employs him or her at the end of each one-year anniversary of the date the option was granted.
- 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.
- Shareholder approval: The company should generally have shareholders approve the plan, both for securities law reasons and to cement the ability to offer tax advantaged incentive stock options.
- 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 those shares. Doing so allows the company to keep share ownership in the company to a limited group of shareholders.
- Financial reports: For securities law reasons, the plan may require that periodic financial information and reports are delivered to option holders.
- Exercise price: How much does the optionee have to pay for the stock when he exercises his 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.
- Term of option: 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).
- 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 repurchase or rights of first refusal on any potential transfers.