Options:

 

We briefly spoke about both options and vesting schedule during the introduction to the economic terms in a term sheet. As the name suggest, an option, gives the bearer of that option the right but not an obligation to purchase a company share at a pre-determined price or at a discount with respect to market price. Such price is called the exercise price or strike price. An option is a contract between the company and the option holder and will have a termination date; meaning, the right to purchase the stock at the strike price will expire at a pre-detrmined date. All unvested options disappear at their termination date. If an employee has not exercised options that were allocated to him.her, those options may be moved back into the employee options pool.

 

Cash strapped early stage companies hire employees by enticing them with attractive options package. Early stage/pre-revenue stage companies have a low valuation and the small team of employees cany make high impact contributions that can lead to exponential growth and valuations; all translating to a large upside when the employee exercises his/her options.

 

Venture capitalist understand the value of options as a hiring tool and want to make sure that the company has allocated a reasonable portion for the employee options pool during the financing round. The structure and size of employee options pool during a financing round can have a significant impact on the pre-money & post-money capitalization table and effective pay out to the founders and investors in a liquidity event. making this one of the more actively negotiated terms on a termsheet. These examples will further illustrate the implications of changes to options pool size and structure.

 

Vesting:

 

Options are not immediately made available to any employee upon joining the company. The allocation of options to an employee happens over a period of time called vesting schedule. The specific schedule for allocation of options to an employee over a period of time is referred to as the vesting schedule. Before I proceed, let me clarify that shares, can also be allocated to employees, but, direct share allocation is limited to key technical personnel and senior executives.

 

Here is a simple example on vesting: An employee joins a company and is offered 48,000 options that are vested over 4 years. No options are allocated to the employee till the end of year 1. At the end of year 1, the employee is allocated 25% of the options; meaning, the employee can now immediately exercise 12,000 options to purchase stock at a discounted rate. This is called the cliff. The remaining options are uniformly allocated monthly over the next 3 years. Meaning, the employee will be allocated 1,000 new options at the end of every month till the end of year 4. Additionally, the company may have an additional term stating that all unexercised options will expire at the end of year 5.

 

A lot can happen during the 4 year vesting schedule of a startup. Additional provisions are written into the vesting schedule for the treatment of unvested options in case of a merger or acquisition (we have briefly touched upon assumption of options topic in the discussion on the letters of intent).

 

Single trigger accelerated vesting is triggered by a change of control activity (merger or acquisition) and causes any unvested options (or a large portion of unvested option; for example one year worth of allocation) to immediately vest. Single trigger options are less common as the employee receives options irrespective of whether or not the employee continues with the new employer. The main advantage of single trigger acceleration is that the buyer does not have to deal with assumption of options. Since options are converting to common stock, the startup would have to share proceeds of the acquisition among new shareholders and for that reason, it may not be preferred by founders and investors.

 

Double trigger accelerated vesting is more widely accepted for handling options allocation in case of change of control. The first trigger for the accelerated vesting is the change of control (merger or acquisition) and the second trigger is no-cause termination of the employee. Accelerated vesting occurs if an employee is terminated for no-cause within a pre-defined period following a change of control event. In case of such eventuality, all unvested options or a large portion of unvested options (for example one year worth of allocation) are immediately vested. This strategy for managing vesting in case of mergers or acquisitions creates future incentive for employees who continue to work after the acquisition. Since not the entire unvested but allocated employee pool is vested, the potential dilution of the proceeds from the sale is also limited.