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 NEWSOpting for negotiation and understanding By Esther Chapman December 1, 2000 Confused by the legalese in your stock option agreement? Three experts parse the bureaucratic boilerplate
Between the lines of boilerplate and legal mumbo jumbo, it's difficult to see how this stock option agreement will play out in the long term. What exactly is vesting? Who sets the exercise price? How do you exercise those options? And what exactly is negotiable? To answer those questions, we had three experts evaluate a sample stock option agreement. James Dunn is a partner with Ernst & Young, a consultancy firm in Washington, specializing in equity-based compensation for early-stage companies. Gabriel Fenton is an options expert with PaineWebber in San Francisco and co-author of the book Employee Stock Options: A Strategic Planning Guide for the 21st Century Optionaire. Debra Mayfield is an attorney with Shapiro, Israel & Weiner, in Boston, and handles employment, intellectual property, and information technology matters. Gather the goods Step one on your stock option journey is to gather the key documents, say our expert panelists. Elementary as it may seem, many executives fail to see how various plan documents impact each other. By neglecting even one, you may be setting yourself up for problems down the exercise line. What are and who has those key documents? The documents include the Equity Incentive Plan, the Grant Letter, the Stock Option Agreement, and the Notice of Exercise, all of which should be provided to you when the employment offer is made. A word of start-up caution: Early-stage companies often do not have a plan in place. If that's the case, ask for a proposed plan draft. Other helpful resources include the Stockholder's Agreement and the Company Bylaws, which executives often must sign as a condition of employment. These documents might include terms that could limit your ability to sell shares or require you to sell under certain circumstances that you may not have control over and that you may find less than ideal. Terms that affect your subsequent cash flow and option wealth include rights of first refusal, which give the company rights to buy back your shares before you sell them to a third party; cross purchase provisions, which are your rights to purchase stock in subsidiaries of the employing company; and other rights of repurchase. Access to the Stockholder Agreement or Company Bylaws doesn't mean you'll be able to alter their terms, attorney Mayfield says. "In some cases, you can negotiate your employment agreement to help neutralize the effects -- for example, by changing the conditions for termination." When negotiating with a privately held company, get your hands on a copy of the most recent business plan. "After all, not every emerging technology company results in a successful IPO," Mayfield says. Analyzing the business plan may give you insight as to whether your potential new employer has a shot at going public. If you're negotiating for stock options, don't assume you cannot review the business plan and other key documents, Mayfield says. "In negotiating an employment offer that involves stock or options or any other securities, executives are entitled to request the same types of information provided to other purchasers and offerees of unregistered securities," the attorney says. In other words, insist upon access to that information. Armed with the relevant documents, you can get down to the nitty-gritty of evaluating the stock option agreement. Here's what our experts say about sections of the sample agreement we provided them. Terms from the plan are denoted in italics. Term 1: Share quantity and price This is the bragging rights term: how many shares and at what price. Our sample Stock Option Agreement offers the potential employee options on 100,000 shares at the exercise price of $10 each. "The number of options is the most important item in the document, and the most negotiable," Ernst & Young's Dunn says. "You should think in terms of the percent of the company that the number of options represents. Ask about the total number of shares outstanding so you know what percent of the company you're getting." Dilution is the word to watch for: The more stocks or options a company issues, the more your ownership interest is diluted. To guard against this, you might focus on negotiating for a fixed percentage of the company rather than the number of options. The company would then have to increase your number of stocks or options every time dilution occurs, Mayfield says. It's not unusual for start-ups to offer NSOs (nonstatutory stock options) -- which trigger taxable events -- without a Stock Option Agreement in place. Instead, your Employment Agreement may refer to the company's intention to create a plan and outline what those terms would be. It's a show of good faith on their part, but there's no guarantee they will ever "show you the money," according to Mayfield. Negotiation point: If you face that situation, Mayfield suggests negotiating a clause into your contract that provides for monetary compensation in case a Stock Option Plan never materializes. "You might put in writing that if there isn't a plan in place by your 1-year anniversary with the company, you will receive monetary compensation equal to a percentage of the value of the options. By the second anniversary, you'd receive another percentage, if there's still no plan, and so on," Mayfield says. "In essence, you're vesting cash in lieu of vesting options." Term 2: Exercise price of a nonstatutory stock option Our sample Stock Agreement Plan can be difficult for even the best minds to decipher: [The] exercise price of each Nonstatutory Stock Option granted prior to the Listing Date shall be not less than eighty-five percent (85%) of the Fair Market Value of the stock subject to the Option on the date the Option is granted. ... Notwithstanding the foregoing, a Nonstatutory Stock Option may be granted with an exercise price lower than that set forth in the preceding sentence if such Option is granted pursuant to an assumption or substitution for another option in a manner satisfying the provisions of Section 424(a) of the Code. Huh? Start with the exercise price of ISOs (incentive stock options), which is non-negotiable due to Internal Revenue Service limitations. ISOs receive favorable tax treatment, so the IRS requires the exercise price to equal or exceed the fair market value of the stock on the date listed on the Stock Option Grant Notice -- the grant date. Negotiation point: ISOs aren't negotiable. But NSOs -- options that don't meet IRS requirements to be ISOs -- are a different matter. You can negotiate the exercise price on NSOs within the company-imposed restrictions in the Stock Option Plan. Our sample plan, for instance, states that the NSO exercise price cannot be less than 85 percent of the fair market value on the date of grant. So if the shares in our sample plan were worth $10, the company might agree to an exercise price as low as $8.50 a share. This situation is possible, but fairly unusual, Dunn says. "A below-market exercise price causes the company to reflect an accounting expense. And since this reduces earnings, most companies will not want to do this," he says. Term 3: Vesting provisions Twenty-five percent (25%) of the shares vest one year after the Vesting Commencement Date. Twenty-five percent (25%) of the shares vest monthly thereafter over the next three (3) years. Simply put, vesting is the "when" of playing your options, the date at which they become available to exercise. "The language in the sample vesting schedule is somewhat confusing. But I interpret it to mean that you can exercise 25 percent of the shares in one year, and another portion of the grant vests every month thereafter until all are vested at the end of the fourth year," Dunn says. A 1-year waiting period is common and often non-negotiable. Companies do this to create a retention tool. But an executive's dream of immediate vesting occasionally occurs, Mayfield says. "Some companies, particularly start-ups, find it hard to get people on board because of their lack of cash. They may provide an immediate incentive to get you on board, followed by a 1-or 2-year waiting period for the next vesting to entice you to stay with the company," Mayfield says. Negotiation point: Considering an exit strategy when negotiating to come on board seems counterintuitive. But it's wise to think through how your options will be treated if you resign or are fired. For example, many plans allow executives to accelerate vesting if their resignation is related to an acquisition. In negotiating, you also want to shoot for fairly broad conditions for acceleration -- any change in title, salary, or work location, Fenton says. Also, examine closely how both the plan and the accompanying Employment Agreement define "termination with cause." When "cause" means anything related to the sufficiency of your performance, the employer has wide latitude in firing you and, in some cases, confiscating exercised and/or unexercised options. Make sure this definition is fairly specific and objective, and that you can still exercise options when terminated, Mayfield advises. Term 4: Early exercise If permitted in the Grant Notice ... and subject to the provisions of this option, you may elect at any time that is both (i) during the period of your continuous service and (ii) during the term of your option, to exercise all or part of your option, including the nonvested portion of your option ... Sometimes you don't want to wait out the vesting schedule. An early exercise perk allows you to choose when to exercise all or part of your options. This, in essence, overrides the vesting schedule. Why would employers allow this? In many cases, it's a win-win situation. The company lands a leading player and the executive receives substantial tax advantages by paying capital gains tax instead of ordinary income tax on the stock purchase. Keep in mind, however, that there's a risk. If the stock price goes down, you've lost money, Mayfield says. You'll also probably face restrictions on the stock, placed by the company to encourage you to stay. For example, they may claim the right to repurchase the stock at the exercise price if you leave before a certain time has elapsed. Negotiation point: It's advantageous to have an early exercise term. Center your negotiations on why you're worth an early exercise term and how that will be an incentive to work toward increasing the stock's value. "Executives should use the same strategies they would use to negotiate more compensation up-front, pointing out that early exercise is also beneficial to the company because you're not asking them to come up with the cash," Mayfield says. Stock options are an innovative and perhaps, but not always, lucrative way to make that new career change worth your while. They are also extraordinarily complex, however, and should be handled with care to make sure you end up on top. Before you make the leap, it's advisable to run the agreement by your attorney or accountant, Mayfield says. Better to find out now if the best option is actually no option at all. Esther Chapman is a free-lance writer in Omaha, Neb. Contact her at chapman@phonenet.com. This article is not intended as a substitute for legal advice.
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