Option Agreement: 5 Key Points for Developers to Check

Nowadays, such motivational methods as cookies and delicious coffee have become commonplace, and even a game console with snacks will not surprise you anymore. Thus, IT companies more and more often offer their partners a new way of motivation – options, emphasizing the fact that they will become a part of the company. Yes, options can serve as a mechanism for incentivizing the company’s top management.  Successful and promising employees and contractors are offered options to keep them on the IT company team.

But is it really as exciting as companies promise? In this article, we will try to outline 5 key points that a developer should pay attention to before concluding such an agreement.

 

I am Offered Stock Option, but What Does It Mean? 

First of all, we should clarify what an option is and what it is for. In general, an option (stock option agreement) is a separate type of contract, according to which the Company gives an individual (an employee or a contractor) the opportunity to buy shares of a company at a fixed low price.

Granting stock option offers is carried out not only for the purpose of motivation for employees, consultants and partners, but is a “must-have” for attracting investments by the Company in the future. After all, having an option plan greatly increases the chances that the company’s best talents will stay with the company at least for the duration of the option.

The option contracts with the company. That is, the parties are an employee or contractor, on the one hand, and the company on the other hand. Therefore, pay attention to who will sign the contract with you – it can only be the company in which the option is granted.

 

How do Options Work?

The main trick of the option is that the option does not give you the shares immediately, but only the right to redeem them in the future under the conditions agreed in the option agreement, which is signed between the company and the recipient of the option.

That is, certain conditions and contingencies are agreed upon. In other words, it looks like this: here’s an opportunity for you, but you can exercise this opportunity only if a certain contingency occurs. For example, to work faithfully in the company for 3 years, not to break any agreements, not to be fined, not to violate the NDA, etc. If these conditions are met, you will be able to exercise your right to purchase stock. 

At the same time, such an employee or contractor continues to receive a salary or fee for services. That is, the right to redeem company stock is additional to the usual compensation under the agreement governing the cooperation of the parties.

 

At first glance, this sounds exciting. But let’s be more specific about the agreement. Next, let’s focus on the key points that a developer should check before signing an option agreement.

1. Option Price.

An option contract usually entitles you to a discount on the purchase of stock. So, even after the contingency conditions are met, the stock is not granted for free. The option implies the ability to purchase them at a discounted price.

Such a price must be specified in the option contract. This is usually the price per share, which is lower than the face value because of the significant discount given to the employee or contractor. The size of the discount can be up to 90%, it depends on the arrangements.

It is worth noticing that a certain price will only be valid for the term of the option contract. Thus, such an offer is limited in time.

Make sure to check if the price of the stock is fixed or what factors affect the price of the stock. If we are talking about giving a certain discount, to what price will that discount be applied?

2. Option Type

The second important thing to check is the type of option. The thing is, a common mistake is to confuse ISO with NSO.

One of the main differences between ISO (Qualified Incentive Stock Options) and NSO (or NQSO, Non-Qualified Stock Options) is that ISO can only be granted to employees, whereas NSO can be granted to consultants, advisors, directors as well as employees.

That is, NSO works for both employees and consultants, as well as for contractors, while the range of subjects to whom the company can provide ISO is much narrower – it comes down to employees. It is crucial to determine correctly what type of option takes place in a particular case. Although NSOs work in both cases, most early-stage companies have a growing tendency to give their employees stock options in the form of ISOs rather than NSOs. The answer lies in the significant tax differences because a company benefits from many tax advantages when it grants an ISO.

In addition, option types have a number of other differences. According to U.S. law, we have identified several of them: ISO must be exercised within three months following termination of employment, even if the former employee continues to provide services in the status of the contractor. ISOs must be held for more than two years after grant, and the shares obtained upon exercise of an ISO must be held for more than one year after exercise. In addition, there are restrictions that ISOs must be exercised within ten years of the grant date.

If the ISO is not compliant with the respective requirements, it will automatically be treated as an NSO, whether the company wants to or not.

Below is a basic table showing the key differences between ISO and NSO.

	ISO	NSO
Who may grant	Corporations only	Corporations, LLC, Partnerships
Who may be a recipient	Employees only	Employees, contractors, consultants, directors
Taxes	There are tax benefits	There are no tax benefits
Exercise after termination	Must be exercised within three months (longer following death/disability)	Set by plan/option No later than the expiration date of the option
Value Restrictions	Only $100,000 can become exercisable in any one calendar year per employee	No restrictions
Transfer	Only upon death	Set by plan/agreement
Expiration	No more than 10 years from the grant date (or, in the case of 10% stockholders, no more than 5 years, as noted above)	Set by plan/agreement

 

3. Cliff and Vest: What is the Difference?

The other major point to pay attention to in the option contract is the cliff and the vest. Therefore let’s study what these are.

Vesting period – this is the term of the option contract, during which the recipient is given the right to demand a certain number of shares. For example, the contract provides for the right to purchase 7,200 shares, the vesting period is 36 months, so 7,200/36=200 shares each month will be added to the right to demand from the company under the option.

Cliff is a kind of limiting factor that is part of the vesting period. During this period, the person to whom the option is granted cannot, under any circumstances, exercise his or her right to purchase shares. Often the cliff is established for a period of 1-2 years.

To make it clear, here is an analogy. The vesting period somewhat resembles a deposit, or rather the interest on the deposit. As with the interest on the deposit the amount accrued grows, so with the vesting period the shares are issued, and gradually they become more and more numerous during this period. At the same time they are to some extent unobtainable. You already have the right to them, the percentage of shares gradually increases, but they are not yet in your hands. The same is with the interest on the deposit: you have it, you observe how the accumulated amount increases, but you get the amount later. At the same time, under certain circumstances, you can exercise your right early. Some deposits can be terminated early. The option can also be exercised before the end of the vesting period in certain cases, for example, if the company goes bankrupt.

At the same time, cliff can be likened to a probation period in a new job. During the cliff period, the company may terminate its cooperation with an employee, contractor, or partner. If such cooperation is terminated, the company’s obligations under the option are cancelled.

Almost always a cliff is set along with the vesting period.

Thus, vesting schedule is established in the option contract. It sets out when and how much interest the employee, partner or contractor will receive. During the vesting period the interest is “accrued,” at the same time it cannot be bought or sold during that period except under certain circumstances. At the beginning of the vesting period, a cliff is set, which is the limiting factor. 

4. The Type of Stock and Why It Matters

It is crucial to understand what type of stock the option grants the right to purchase. There are two types of shares: common shares and preferred shares. Under an option, the right to redeem preferred shares is usually granted. These shares do not give you the right to vote or otherwise make decisions about the future of the company, nor do they give you the right to appeal. However, preferred shares give you the right to receive profits through dividends. As a matter of fact, they are received for the sake of the latter.

That is, the key difference between common shares and preferred shares is that the former give the right to vote, while the latter do not.

In addition, it is not as important how many shares you can buy with the option as it is what percentage of the total number of the respective type of shares they represent. 

5. Reality of the occurrence of a contingency

The principle of the operation of an option presupposes the occurrence of a certain circumstance, i.e. a circumstance that may or may not occur in the future. The occurrence of this circumstance determines whether the consequences under the contract will occur. This is why it is fundamental to assess the likelihood  of the occurrence of such an event. If the prerequisites are to work for the company for 50 years without a performance error and to exceed the KPIs by 700%, then you should hardly expect a real opportunity to purchase shares under such an option.

The conditions of such a circumstance should be examined in detail. Is it even possible for it to occur (sometimes in fact, to be achieved)?

In general, it is important here to study the requirements carefully, understand for yourself the factors determining the fulfillment of these requirements, and decide whether you agree to them.

 

To sum up

Giving options to partners and up-and-coming employees is a great way to motivate them to stay on the team.

At the same time, an offer to enter into an option agreement can be a tremendous opportunity for such an employee or partner. However, it is essential to fairly assess the terms of the option agreement, not to conjecture about what’s not really written, and to build realistic expectations about what, when, and how one might get as a result of such an agreement.

Thus, to study thoroughly the terms of an option contract or to prepare an option for a specific case, we advise you to seek professional help to avoid future discrepancies between expectations and reality.