Options grant employees the right to purchase company shares at a predetermined price in the future. They serve as a risk-free incentive, providing participants with the chance to partake in the company's future growth.
Options typically come with a vesting period and an expiration date. During the period between the vesting date and the expiration date, the employee is required to exercise the option. The option also has an exercise price, also known as a strike price, which is the predetermined amount at which the shares can be bought. Generally, it is a requirement for the employee to remain employed by the company from the grant of the option until the vesting date in order to earn the rights to the option. Consequently, if the participant chooses to leave the company after the vesting date, they typically do not forfeit the option. The employee has the ability to exercise this right starting from the vesting date until the options reach their expiration date.
How to set the strike price?
Options are typically granted with the expectation that participants will benefit if the share price increases. Therefore, it is common practice to grant options with an exercise price matching the market price at the time of the grant, preferably using a volume-weighted average a few days prior, especially for listed companies with frequent trades.
However, there are no restrictions on the selection of the strike price. If you anticipate a significant rise in the share price and wish to provide participants with an ambitious target, you can set the strike price slightly higher. It is often customary to define a certain percentage above the market price as a reference. In such cases, we recommend establishing the strike price at the outset and avoiding annual increments after the allotment.
How long is the vesting period?
When determining option terms, it's vital to evaluate the company's situation and the recipients. If the company anticipates a pivotal milestone in three years, aligning the vesting period to this timeframe maximizes the options' impact. However, gauge if employees might find a three-year wait too long. Options are designed as long-term incentives. To balance immediate rewards with long-term goals, consider a staggered payout: 25% after the first year, another 25% the next, and 50% in the third year. This structure keeps participants engaged, especially if the company's value rises, ensuring they benefit over time while still offering some earlier rewards.
Exercise of options?
When exercising or redeeming the options, it is most common for the employee to pay the strike price to the company and receive one share per option exercised. This is typically done through the company issuing new shares, although the company may also choose to use shares from its own portfolio or acquire shares specifically for this purpose. In some cases, participants may also receive a settlement from the company based on the difference between the exercise price and the market price at the time of exercise (known as synthetic settlement).
However, this type of settlement requires that the market price can be determined relatively objectively, and therefore works best in companies that have a liquid market for trading, such as those listed on a stock exchange. Otherwise, it is important to agree in advance on how the share value will be determined when the time for exercise arrives.
Set expiration date
Setting an expiration date for options serves multiple purposes.
- It minimizes potential confusion by preventing an overflow of options, especially when the share price dips below the exercise price, rendering the options less likely to be exercised.
- It ensures former employees don't indefinitely hold onto vested options, with many option agreements already containing measures against this.
- For companies abiding by International Financial Reporting Standards (IFRS) in their financials, delayed expiration dates might inflate accounting costs.
For greater flexibility, it's advisable to have a buffer between the vesting and expiration dates. This accounts for unpredictable corporate events and market fluctuations that could influence decisions around option exercise, particularly during low share price periods.
By adopting the proposed vesting structure, you can consider setting the options to expire five years after allocation, regardless of the vesting period. This ensures that the final award is earned two years before the options expire.
Advantages of options
- No risk for participant.
- No taxation for participants before the option is used.
- No employer's contribution before any gain on the options.
- No actual dilution for shareholders unless the company value increases during the period (provided that the strike price corresponds to the market price at the time of allotment)
- Binding effect on key employees and perceived value in times when the share price rises and remains stable.
- Higher “leverage” than for ordinary shares as the participant will have more options (due to lower cost and dilution per instrument).
- Options are nothing more than an agreement before they become an actual share. This makes it administratively efficient to administer. You do not need a structure for share accounts etc. before the options become actual shares (note, however, accounting management under IFRS).
Disadvantages of options
- Gains on the option are taxed on wages, in addition the company is obliged to pay employer's tax on this.
- No direct "skin in the game" can be considered negative for the company.
- Low binding effect and perceived value if the share price falls over time.