In Short
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Share options grant the right, not the obligation, to acquire shares in the future.
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Vesting conditions must be met before options can be exercised and converted into shares.
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An exercise price is required to convert options into shares, usually paid in cash.
Tips for Businesses
If offering share options to employees, ensure clear terms on vesting conditions and the exercise price. Align the vesting schedule with key business milestones to motivate performance. Be transparent about what happens if conditions aren’t met to avoid misunderstandings and ensure employees understand the potential value of their options.
A company can issue different types of ‘securities’ in itself. The main security that a company will issue to entities is called a ‘share’. Another type of common security that a company issues is an ‘option’. An option is not as straightforward as a share and has different benefits and rights attached to it. This article will explore practical considerations you should understand when you want to receive share options in a company.
How Do Options Work?
An option is a type of security where the company will grant you the right, but not the obligation, to receive a share in the future after fulfilling certain conditions. After receiving an option, you will become an ‘optionholder’ in the company.
When a company grants you an option, it does not issue the option as it would issue a share. For example, suppose a company has a total share capital of 100 shares. They then grant you an option that will oblige the company to issue you an additional 10 shares on top of the 100 shares (after meeting certain conditions). In this case, the number of shares in the company stays at 100 until you ‘exercise’ (convert) the options into shares. When exercised, 10 new shares will be ‘created’ and issued to you.
Notably, options benefit the company and affect your rights in the company. You, as the optionholder, do not become a shareholder until your options convert into shares. As you will not be a shareholder until that time, you are not able to vote on shareholder matters or receive dividends.
Key Stages to Receiving and Exercising an Option
Once you receive an option in a company, you now have the right to receive a share in the company at a future point in time.
For the benefit of the company, options usually have certain conditions attached to them that must be fulfilled before you can convert your options into shares. Such conditions include ‘vesting’ conditions and an exercise price.
The first condition is the vesting conditions attached to the options. Once the vesting conditions are satisfied, only then can you exercise (convert) the options into shares (provided the options are able to be exercised at that point in time). If you can exercise the options, you will then need to provide the company with an ‘exercise notice’. Likewise, you must pay the company the ‘exercise price’ of those options.
Continue reading this article below the formVesting Conditions
Options usually have vesting conditions attached to them, as well as time and key performance indicators (KPI). Vesting allows you to earn the value of your options over time.
Time-Based Vesting
With time-based vesting conditions, you cannot exercise options into shares until reaching a certain point, or certain points, in time.
For example, you receive 100 options in a company with a total 2-year vesting period, with the options vesting every 6 months over the 2-year period. If you later receive the options on January 1 2024, the options will vest as follows:
- 1 July 2024: 25 options;
- 1 January 2025: 25 options;
- 1 July 2025: 25 options; and
- 1 January 2026: 25 options.
On 1 July 2024, you will have 25 options vest and can exercise them into shares. You can do this on each of the remaining time events above.
KPI-Based Vesting
With KPI-based vesting conditions, options cannot be exercised into shares until satisfying a certain KPI or multiple KPIs.
For example, as in the same scenario above, you receive 100 options in a company with the options vesting on 1 July 2024. However, the options vest if the company has reached $100,000 in gross income for the 2023/2024 financial year. If you satisfy the vesting condition, you can exercise the options into shares.
Exercise Price
The option deed is a document outlining the terms and conditions relating to the options. Either the deed or an offer letter will set out the:
- number of options; and
- price you must pay to the company when exercising the option (converting into a share).
An offer letter is more common in the case of an employee share option plan.
What Happens if You Do Not Meet the Vesting Conditions?
If you do not meet the vesting conditions, the company will deal with those options according to whether they are ‘vested’ or ‘unvested.’ A company will typically buy-back vested options at the full market value of a share in the company at the time of the buy-back. Unvested options ‘lapse’ and fall away for no value.
For example, suppose in the context of an employee share option plan, you receive 100 options with a total 4-year vesting period, with the options vesting quarterly across those 4 years. If you leave the company after 2 years, you will have 50 vested options and 50 unvested options. The unvested options lapse and you get no value for these. The company may buy-back the vested options, where the price of each vested option matches the value of a share in the company.
Exercise Condition
You will have a specified period in which you can exercise your options. You and the company will agree to this period which is then set out in the call option deed or offer letter (under an employee share option plan).
Depending on the agreement between the parties, you might exercise an option at any time once the option has vested or after fulfilling specified conditions (e.g. achieving pre-agreed performance milestones). A condition can also be attached whereby the options are only exercisable upon a sale of the business or listing on the stock exchange.
This guide will help you to understand your corporate governance responsibilities, including the decision-making processes.
Key Takeaways
When receiving an option, there are many items to consider. Options can come with different conditions, which may affect whether or not you can exercise them and convert them into shares. It is vital to understand what an option is and how it works, as options are not the same as shares.
For more information about buying, receiving or exercising share options, our experienced business lawyers can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
What are share options, and how do they work?
Share options grant employees the right, but not the obligation, to purchase company shares at a predetermined price in the future. Employees typically become ‘optionholders’ and can exercise these options once specific conditions, such as vesting periods, are met.
What happens if vesting conditions aren’t met?
If employees fail to satisfy the vesting conditions attached to their share options, they forfeit the right to exercise those options. Unvested options typically lapse, meaning employees cannot convert them into shares.
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