Stock Option Plans: How do we hire people without any money? 

My start-up clients often ask me how they can hire the proper talent they need in order to build their platform/business given they’re not yet making any money.

It’s not an easy answer, by any means, and is as much, if not more, a business question than it is a legal question.  However, from a legal perspective, one tactic that is often used is to implement a stock option plan.

Stock Option Plans

A stock option plan can have two main functions: to hire new talent and to incentivize future loyalty.  Ultimately, whether it’s one or both depends on when a stock option plan is put in place.

No employee wants to work for free and start-ups usually struggle with cash flow so it is very difficult to pay the high wages that are usually demanded by the best talent.  One way around this is to offer your employees a stake in the value of the future growth of your company.  By issuing stock options to your employees, subject to the terms and conditions of your stock option plan, they can own a small part of what you all hope will become a very large pie.

Hiring and Retaining Talent

Stock options can help hire new talent by allowing the company to offer new employees a lower salary with the promise of a hopefully larger long-term benefit through part-ownership of the company.  The lure of being bought out down the road can make those options worth more to the potential new hire than pure salary might be.  If it works out and the company is purchased at some point in the future, potential capital gains tax treatment of the sale of the underlying shares in that transaction can make the options even more valuable to the employee than pure salary would have been.

Stock options can help retain talent for the same reason.  The lure of a much larger and possibly more tax-efficient pay-day.  Stock options also help with talent-retention by virtue of how they work.  Most stock options vest over a number of years.  Vesting means the options become exercisable, usually in part, over time and usually require that an option holder remain employed with the company in order for additional options to vest.  This buys the company loyalty.  It makes option holders want to stick around and continue to help the company increase its value so they can earn their “pay-day”.

ESOP’s and Option Agreements

An option granted to an employee by an employer gives the employee the right to pay his or her employer a pre-determined price upon the occurrence of certain established conditions in exchange for a fixed number of ownership shares in the company.

There are a number of different variables that can apply to granted options and those will be set out in the underlying stock option plan (the “ESOP”) and/or in the option agreement entered into between the company and the employee to whom options are granted (the “Option Agreement”).

The ESOP will set the basic rules applicable to all options.  The Option Agreement can include deviations from the basic rules each time the Board of Directors of the company grants options to any person.  Typical variables include, the number of shares issuable upon full exercise of the options granted, the vesting rate of the options (more on how that works below), the exercise price payable per share, the termination/expiry date or conditions applicable to the options and what happens in the event the option holder is terminated from his or her employment or when the company is purchased.

It’s the exercisability of the options that allows the holder to pay the company the exercise price and to receive shares in the company as a result.  Unvested options will automatically expire after a certain period of time if an employee is terminated for cause or without cause or if he or she resigns.  How long that period of time is depends on why their employment ended.  If for cause, then unvested options usually expire immediately upon termination as do any unexercised options.  If by resignation, the unvested options usually expire upon resignation but vested and unexercised options are given a short window to be exercised.  If terminated without cause/notice, then the basic rule is usually that unvested options immediately expire but vested and unexercised options continue to be exercisable for a short period of time (often in the area of 6 months).  It does happen though, as part of the negotiations between the terminated employee and the company, that unvested options can be accelerated and become exercisable often for the same period of time as any already-vested but unexercised options do.

Take-Aways

Stock options are an important part of the total compensation regime available to employers, especially start-ups.  They help employers hire the right people to build the business and also to retain those same and other employees over several years.  They all hope that this will ensure the long-term success and ultimate sale of the company so they can all receive that larger pay-day everyone hopes for.

If you have questions about starting your business, including about business formation and organization, business operations, compensation for employees, or any other day to day matter, contact the Toronto corporate lawyers at Mills & Mills LLP at 416­-863-0125 or send us an email.

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