In order to attract and retain top talent, many companies offer their employees incentives in the form of options or shares. Companies usually establish an Employee Share Scheme (ESS), or an Employee Share Option Plan (ESOP). This provides the employees with options, or the right to acquire shares in the company at a specified time if the employee meets certain conditions. This condition is usually a certain length of service at the company, thus incentivising the employee to stay. If the employee does not fulfil these conditions, the options are known as unvested options. This article will discuss what happens to unvested options if founders and investors in a company decide to sell the company and thereby ‘exit’.
What is an ESOP?
An Employee Share Ownership Plan (an ESOP), or Employee Share Scheme (ESS), is a scheme that provides employees with an ownership interest in the company by giving them company shares or options.
What Are Options and Unvested Options?
When employees receive options under an ESOP, they receive a right to buy shares in the company for an agreed price (also known as the “exercise price”) at a specified time in the future. When employees exercise their options, they convert their options into shares.
However, options normally cannot be exercised immediately. Employees need to fulfil certain conditions first. Typically, one of the conditions is a certain length of service at the company. This is called a vesting period. This vesting period is usually between three and five years.
During the vesting period, the employee holds the options but are generally not entitled to dividends or voting rights. More importantly, they cannot sell their options. When the employee fulfils the conditions, the options vest and the employee can exercise their options. This means they convert the options to shares by paying the relevant exercise price. The employee will then usually receive the full benefits of being a shareholder.
In many startups, the vesting period is four years, with a one-year “cliff”. The “cliff” means that if the employee leaves the company within the first year, no options will vest. Instead, 25% of the options will vest exactly one year after the grant of the options, and continue to accrue every month for the length of the vesting period. This continues until the employee accrues 100% of the options.
An unvested option is an option that has not vested because the employee has not fulfiled the vesting conditions.
What Happens to Unvested Options in Case of an Exit Event?
An exit event is when the owners of a company “exit” the business by selling the business. The three main methods of exiting are either by:
- listing the company (Initial Public Offering, or IPO);
- selling the assets of the company; or
- selling the shares of the company.
If your company has an ESOP in place, the rules of the plan and the associated offer letter should set out what happens to any unvested options in the event of an exit event.
Usually, the rules give the Board of Directors of the company some discretion about how to deal with employees’ options, including the unvested options. The Board may decide to:
- buy back or cancel the options at their fair market value; or
- allow the outstanding options to vest.
Companies often use option plans to retain key talent and provide employees with a long term incentive to stay with a company. When the owners of a company exit the business by selling the company, the Board of Directors will either buy back or cancel unvested options at their fair market value or allow the outstanding options to vest. If you have any questions about ESOPs or unvested options, get in touch with LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.
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