Options for Purchase of Shares
In the context of companies, an option is a right provided by a company to another person or entity to purchase a set number of shares of the company at a particular price, regardless of the actual value of the shares at the time that the option is exercised. Options can represent very valuable assets if the holder is able to sell the shares purchasable upon exercise of the option at a higher price than the price payable to exercise the options.
Many start-up companies, especially in the hi-tech world, initially pay founders and consultants in whole or in part by granting options to them when they have little in the way of cash. Often companies of all stages of development will also grant options to employees as part of their benefit package. Options are seen as a useful tool for companies to incentivise their employees and keep them vested in remaining with the company and contributing towards the company’s success. While they offer a potential high value in the future, they are not the actual shares of the company and the rights of shareholders are not attached to them. Option holders have no right to vote with shareholders, receive dividend payments, receive a share of the assets upon a liquidation of the company nor do they enjoy any other rights of the shareholders. Additionally, until an option is exercised and a share issued and allotted to the exercising option holder, the rights of the existing holders are not diluted by the options.
Options may also be granted to investors in private companies to provide them with a form of additional benefit for the investment. Often these options, sometimes also known as warrants, will provide the investors with a right to invest additional funds in the company at the same price as their current investment, or at a discount on the price paid per shares in a later investment round.
Options will normally include some or all of the following provisions, depending on the circumstances:
- The price payable per share for the exercise of the options
- The number and type of shares purchasable upon exercise of the options
- The period in which the options may be exercised, which is known as the exercise period. Once the exercise period expires, the option holder may no longer acquire the shares
- The method of exercising the options
- What will happen to the options and the shares purchasable under the options in the event that the company is merged with or acquired by another company or if the company effects some form of restructuring of its share capital that renders the shares purchasable upon exercise of the option in its present form obsolete, worthless or substantially different from what it was originally intended to grant to the option holder
- Normally where options are granted to employees and long term consultants of the company, the options will also provide for:
- A vesting period in which the options will become exercisable in blocks over a set period of time – such as a quarter of the shares becoming purchasable each year over the period of 4 years. Normally if an employee or consultant leaves the company before the end of the vesting period, any unvested options will expire and no longer be exercisable;
- Together with the vesting period, the options will define the circumstances in which the vested options will remain exercisable when an employee or consultant leaves the company and the circumstances in which the options will expire. Normally the former occurs when the employee or consultant leaves in circumstances in which they have no fault for the cessation of the relationship with the company and they are often defined as “Good Leavers”. The latter will usually occur when the relationship has ended in circumstances where the employee or consultant is not a good leaver.
- Options granted to employees may also restrict the employee from selling some or all of the shares purchased by exercising the options for a defined period of time following the exercise or grant of the options.
While the granting of options, their exercise and the sale of the shares purchased upon exercise are normally tax events that result in the option holder having a tax liability, both the laws of England and the laws of Israel provide companies with the possibility of granting options to employees under specially defined employee share option incentive schemes that will provide the employees with certain tax advantages over regular options. The rules and regulations that apply to the type of options granted and the method of granting them in order to qualify for the tax benefits will often have a considerable impact on how many of the terms above are to be determined. Often, the setting up of these employee share option schemes requires detailed planning and close cooperation between the company’s lawyers, accountants and tax advisers to ensure that the schemes are correctly set up and managed.
In the UK, companies that carry on certain qualifying trades, with gross assets of less than £30 million and less than 250 full time employees may grant options to its full time employees under the Enterprise Management Incentive (EMI) scheme, which offers considerable tax benefits to the option holders. Options may not be granted to employees that have what is defined as a “material interest” in the company or any of its subsidiaries.
Companies that cannot qualify to grant EMI options may be able to grant options under a Company Option Share Option Plan (CSOP) if they are independent and not controlled by another company. The CSOP enables a company to grant share options to selected executive directors and employees to purchase shares with a maximum value per individual of £30,000 at the date of the grant. The CSOP also offers generous tax benefits upon grant and exercise of the options if the legal requirements for the benefits are met.
In Israel, Section 102 of the Income Tax Ordinance provides Israeli companies with the possibility of setting up employee share option plans which, once approved by the tax authorities and upon compliance with all applicable conditions, also provide the employees with useful tax benefits.
- I advised an English company involved in the catering industry in the establishment of an EMI scheme and the grant to various employees of options under the scheme.
- I advised a consultant being appointed to the Scientific Advisory Board of a start-up company in the field of neurology in connection with his engagement agreement. My client was only to be paid in options to purchase shares and so the terms of the options and the proposed option agreement formed an important part of the negotiation.