One of the most common strategies employed by start-up companies to leverage their limited cash resources and still have the financial resources to compete in the marketplace is to offer key employees, consultants and advisors (among others, and collectively described in this article as “participants”) an incentive known as an Employee Stock Option Plan (“ESOP”). An ESOP is a plan whereby participants will be awarded options to purchase a specified number of shares in the company at a predetermined price (the “exercise price”) at predetermined periods or intervals during the life of the plan.
An ESOP is a win-win proposition for a start-up company as they may be able to attract employees who are willing to forego greater salaries in exchange for the opportunity to participate in the company’s future success and profits. Ideally, participants will also think like an owner because of their vesting interest in the company for which they work.
The participant may be rewarded with a specified number of options during a set period of time but the decision of when and if to exercise these options and purchase shares will sometimes depend on whether the participant has sufficient funds to pay for these shares.
Cashless Exercise of Options
As noted above, the participant may not have the funds available to exercise their options and purchase shares, and in some plans the company through the terms of its ESOP will permit a “cashless exercise”.
How cashless exercise works
A portion of the options held by the participant are “hived off” to be used as currency.
By way of an example:
- A participant holds 100 options exercisable at 100 dollars per share to be purchased.
- The cost to exercise all options (in order to receive all available shares upon exercise) is therefore 100 x $100 = $10,000.
- In this example, fair market value of the exercised options is $200 per share, so fair market value of all shares upon exercise is 100 x $200 = $20,000.
- 50 shares can be “hived off” by the participant to be used as currency, since 50 x $200 = $10,000.
- Therefore without paying any cash, the participant can tender half of their options in order to exercise the other half and will receive 50% of their allocated options.
In many plans the participant is not required to convert all options at once, and can exercise at their own pace, so assuming that the fair market value continues to increase, it may be beneficial to the participant to exercise some but not all options.
Benefit of exercising some but not all options
Until some (even a few) options are exercised, the participant is not formally a shareholder of the company, and does not have any shareholder rights (voting, information, or other rights that may be available, depending on the agreements of the company).
Fair Market Value
Fair Market Value (“FMV”) is an important aspect of cashless exercise, as both the company and the participants will want to ensure: (a) a fair application of the calculation of fair market value to all participants, so that no participants are able to exercise options and receive shares for some value of “consideration” that results in a lower price per share than either other participants in the plan, or shareholders who have paid cash or some other consideration for their shares; and (b) a formulaic determination of fair market value that is easy to calculate, so that participants can plan for exercise with some reasonable certainty on the value of the options and underlying shares/formula for calculating such value.
Among other methods, FMV can be determined by:
- The board of directors acting in good faith
- A recent round of financing
- The auditor in audited financials
- Some multiple of EBITDA (or some other function of income).
Keep an eye out for the options expiry date
The option to purchase shares will expire after a period of time so it is important for the participant to read the expiry provisions in the ESOP. A cashless exercise will make it more convenient for the participant to exercise their rights prior to expiry, as it removes the barrier of “coming up with the cash”.
Benefit to both employer and employee
A private, and especially “growth-stage” company ESOP requires a leap of faith. The participant must buy into the long-term company vision in order to trade a potentially greater compensation in cash in exchange for the prospect of investing in company shares. If the value of the shares does not appreciate, not only would the participant be faced with a low value return for their efforts but, if they decide to exercise options that are “out of the money” in order to cement their shareholder rights, such participant can stand to lose money. A cashless exercise provision in the ESOP will therefore provide the participant with the comfort and benefit of not paying out-of-pocket in cash when exercising their stock options.
Employers and employees both often face financial restraints when they are involved with start-up ventures. Providing a cashless exercise mechanism within an Employee Stock Option Plan allows both parties the opportunity to potentially prosper in the future growth of the company.
Founders and early stage investors should note that an ESOP could dilute their equity in the company, although there are some contractual measures they could take to prevent such dilution.