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EquityZen's Blog On Startups and Their Economics

Demystifying the Option Agreement

Abad Mian | January 12, 2017



Your Stock Option Agreement. If you work at a startup, you’ve probably got one. It lays out what you can and can’t do with your stock options, which happens to be a very important component of your compensation. But do you understand how an Option Agreement really works? Luckily, EquityZen is here to help.


First of all - what document are we even discussing? Startups can use a lot of different terms to refer to the same thing (see this Meditation from EquityZen on the equity documents you should always have on file). Today, we’ll be talking about the Stock Option Agreement, which may be titled as an Option Agreement, Stock Purchase Agreement or something similar. It may be included as part of your Stock Option Grant or Option Exercise Notice. Don’t worry too much about this however. What it basically boils down to is what options are you receiving, how do you exercise them, and what are the terms governing the shares once you’ve exercised?

Stock Option Grant

The first thing you’ll typically see in your Option Agreement is a reference to what options are subject to the Option Agreement, which are usually described in greater detail in your Grant. Your Grant is important for understanding your Option Agreement so we’ll discuss it briefly here. You should’ve received a copy shortly after you joined your company and it will include basic information on your options. Terms you’ll likely see include:

1. Type of Options - options come in 2 flavors - incentive stock options (“ISO’s”) and non-statutory stock options (“NSO’s”). If you’re an employee at a startup, you’ll almost certainly receive ISO’s, which offer favorable tax treatment. For a further look at the difference between ISOs and NSOs check our Meditation on Understanding Equity Compensation.
2. Date of Grant - this is the day the grant was formally issued to you.
3. Vesting Commencement Date - this is an important date that signifies when your options begin vesting. Vesting means your options become eligible to be exercised into actual company shares.
4. Expiration Date - this is the latest that you can exercise your options, typically 10 years after the Vesting Commencement Date. If you leave your company, you will usually have a shorter period (usually 30 to 60 days) to exercise, depending on the particular circumstances by which you left.
5. Vesting Schedule - this schedule determines when the options become yours to exercise. Until you vest, you haven’t earned them yet.. The most common vesting schedule is 4 years with a 1 year cliff, which means that 1/4th of your options will vest after 1 year, and the remaining will vest at a rate of 1/48th per month over the next 3 years.
6. Exercise Price - this is the price per share you will need to pay to exercise your options.
7. Total Number of Shares Granted - this is the number of options you were granted; which are eligible to vest.

Method of Exercise and Payment

This section lays out the procedure by which you can exercise your options. Exercising typically involves delivering an Exercise Notice (which should be included as part of your Stock Option Grant or Option Agreement documents), stating the number of options you wish to exercise and the method of paying for them.

Payment can typically be made by check or wire. If you are exercising as part of a sale, some companies may also allow for a same-day exercise, where a portion of the sale price is used to pay the exercise price.

End of Employment

This section explains how long you have to exercise your options if you leave your company. In the event of death or disability you or your survivors will typically have 6-12 months to exercise. If you voluntarily leave or are terminated not for cause (i.e. laid off), you will normally have 90 days.

Transfer Restrictions

This is one of the most important sections of your Option Agreement, especially if you ever choose to sell your shares. Transfer restrictions spell out whether, and how, you can sell your shares. Liquidity is crucial as many companies are taking increasingly longer to exit. You might want to plan for life events, such as paying off school debt or buying your first home. You may not be able to wait the 10-12 years it sometimes takes a company to exit, in order to plan your life. Additionally, having your wealth concentrated in the illiquid stock of a single company may not be the most prudent approach to wealth management. Being able to sell your shares is important, and understanding the rules that apply is crucial. There are two important types of transfer restrictions you may find in your Option Agreement.

The first is a Right of First Refusal or “ROFR”, which you will find in almost any Option Agreement. A ROFR is the Company’s right to purchase some or all of the shares you were planning to sell rather than allowing you to sell to a proposed buyer. From your perspective, this typically leads to the exact same financial outcome as selling to the original buyer you identified. The company is effectively saying, “Hey Susan, don’t sell your shares to Mike. We’ll buy them from you on the same terms.” A company typically has 30 days to decide whether to exercise its ROFR.

The second primary type of restriction is requiring board or company approval prior to a sale. This is less common than a ROFR, but seen with regularity. Under a board or company approval restriction, the company or its board have the final say on whether to approve or deny a transfer. It’s important to know that this type of restriction is in place before you start at a company, because it's much harder to sell your shares with this restriction in place.

One final restriction you may see is a mandatory lockup period, which is standard. This only applies if your company goes public and will restrict you from selling for a period of up to 180 days after the date of the company’s initial public offering or “IPO”.

Legal Opinions and Transfer Fees

Two more items to look out for in your Option Agreement or Exercise Notice are provisions requiring a legal opinion or payment of a transfer fee for a sale. Legal opinions will typically state that a transfer of your shares do not violate securities laws and can cost between $1,000 to $2,000. Transfer fees are a processing fee paid to your Company and can run between $1,000 to $3,000. Not all companies require a legal opinion or transfer fee and many require neither. However, it’s important to keep transfer costs in mind when contemplating a sale.

Conclusion

That’s a lot to dig into, but it’s crucial that you understand what’s in your stock option agreement before you make a major decision like choosing to exercise your options or sell. And before you leave, why don’t you check out some related Meditations from EquityZen:

Equity Documents to Keep on File
Understanding Equity Compensation
Understand These Points About the AMT Before Exercising Your Options
How to Value Your Private Shares


Note: This column does not create an attorney-client relationship and is not intended as legal or tax advice. For an analysis of your particular legal situation, please contact a qualified attorney in your jurisdiction. For an analysis of your particular tax situation, please contact a qualified tax expert.


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