There are several different ways to provide an employee with a stake in your company. One way is issuing that employee with shares. However, shares might not always be appropriate. Another popular alternative to granting an employee an ownership stake is to issue them options. Sometimes an employee who is an option holder may wish to leave the business. This article will outline what:

  • this will mean for your company; and 
  • happens to that person’s options when they do so.

What Is an Option?

Options are a right to purchase shares in the future. If you provide someone with an option to subscribe for shares in your company, you are giving them a right to pay to convert their options into shares. Options are usually converted into shares when there is a predetermined event or at a specified point in time. Granting an employee options can be a great incentive for that person to help build the success of the business.

Usually, the option holder will have very limited rights in the governance and decision-making of the company, if any at all. The benefit of an option, as opposed to a share, from the company’s perspective, is that you do not treat that option holder as a shareholder. The option holder will not be a party to your shareholders agreement unless they were to convert their options into shares and become a shareholder. 

What Do I Do if an Option Holder Leaves?

Typically, you will issue options to a person under an employee share option plan (ESOP). This plan, along with the particular employee’s offer letter, will set out the: 

  • terms of the options; 
  • the exercise price of those options; and 
  • other associated terms. 

When an option holder leaves, their options may be treated in one of three ways where the options will: 

  1. lapse;
  2. be transferred; or
  3. be retained by the employee.

The terms of the ESOP will usually include an obligation that the employee continues to work for the company. If an employee leaves the company, the company usually has the discretion to decide whether the employee’s options lapse when they leave. If the employee’s options lapse, they will receive nothing.

Alternatively, if you do not want the employee’s options to lapse, you may be able to instead require the employee to: 

  • transfer their options to another person; or 
  • allow them to keep those options. 

Typically, the directors will make this decision by passing a resolution to this effect. 

Where the options lapse in accordance with the ESOP, you will need to cancel those options. This is done by: 

  1. cancelling the relevant option certificates that were initially provided to the option holder and 
  2. updating the company’s register of option holders to show that the options have lapsed and have been cancelled. 

To cancel an option certificate, the company will provide the option holder with a written notice requiring that the option holder destroy their certificate.

Vesting

One key term that is commonly found in an ESOP is vesting, which employees use to ‘earn’ their options. Vesting is generally imposed on the employee’s options by setting out either specified time-frames or milestones they must meet to be able to exercise their options. 

For example, a typical time-based vesting schedule is a 4-year vesting period with a 1-year ‘cliff’. This means that once the employee passes the one year mark, they will be eligible to exercise 25% of their options. Then, over the next three years, the options will vest in equal increments, either quarterly or monthly depending on the case.

If the option holder leaves and their options are subject to vesting, the next steps will be dictated by whether those options have vested or not. Typically, the employee will be able to retain any options that have vested while their unvested options will be cancelled.

If your employee has already exercised some of their options and has been issued with their shares then you will need to consider that person’s shares and their options separately. What happens to the shares will be determined by the terms of your shareholders agreement. On the other hand, the next steps with respect to their options will be governed by the terms of the ESOP.

Key Takeaways

Issuing options to an employee is a popular way to grant an employee an ownership stake in the company. When you issue options to a person, this will likely be done under an ESOP. An ESOP plan will set out the terms of the options, including what happens to the options when an option holder leaves. If you have any questions or you require any assistance with understanding your next steps for a departing employee option holder, contact LegalVision’s business lawyers today on 1300 544 755 or fill out the form on this page.

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