Opting for negotiation and understanding
YOU'RE IN THE final stages of joining a hot new high-tech company as CTO. It's down
to cash and options. You can handle the negotiations about salary and perks. That's
straightforward. But what is that stock option agreement really saying?
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
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
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 rightss 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
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
[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 loweer
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
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
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
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,
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 wwhen 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,
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.