Introduction
What makes a stock option plan or agreement attractive to an employee? The short answer is - the opportunity to make money!
There are three (3) basic ways for an employee to make money on the shares: via dividends; by selling the shares for more than they paid for them; or by participating in the value of the company if it is liquidated.
(i) Dividends
Frequently dividends are declared “at the discretion of the Board of Directors”, which means that the shareholders will get dividends if the Board decides to declare dividends. Often dividends are also not ‘cumulative’, which means that if the Board does not declare dividends in a year, there is no carryover of rights to dividends from that year’s profits in any following year. To make it more likely that employee shareholders will receive dividends, their dividend rights should be tied to the dividend rights of the shareholders who control the company. This can be done in various ways. The ‘employee shares’ could have the right to dividends if any dividends are declared on the shares of the controlling shareholders. Another possibility is to make dividends on the shares of the controlling shareholders payable only after dividends on the ‘employee shares’ have been declared and paid.
(ii) Sale of the Shares
For private companies, especially startups, the employee will likely only be able to sell their shares in one of two situations: to the company under a share repurchase agreement; or to a purchaser making a bid for the company. From the employee’s perspective, it is desireable to be able to require the company (at the employee’s discretion) to repurchase the shares for the price paid plus undeclared dividends (at a minimum). From the employer company’s perspective, it is desireable to be able to repurchase the shares (at their discretion) or if the employee leaves the company, or upon defined financing events.
If a purchaser is making a bid for the company, the employee will want to have the right to participate in the bid to be able to sell their shares for the same price offered to the controlling shareholders. The employee will also want to have an acceleration provision in the stock option plan which permits all the options to vest immediately upon an offer to purchase the shares of the company. This would enable the employee to purchase all the shares under the plan at the exercise price, and sell them into the bid.
(iii) Liquidation Value
The right to participate in the liquidation value of the company is an opportunity to participate in the growth in value of the company. From the employee’s perspective, it is desireable to have shares that participate equally with (or in priority to) the common shares.
The Worst Case Scenario for the Employee
From the employee’s perspective, the worst combination of rights are shares that have only discretionary dividend rights without any preference over or ties to dividends on the owner’s shares; shares that can be repurchased at any time for the price paid by the employee (plus declared but unpaid dividends, if any were declared); and shares that do not participate in any ‘liquidation event’. These shares will bring only the repayment of the purchase price, no guarantee of dividends, and no right to participate in the growth of the business. Worse yet are shares that the shareholder may never be able to sell or receive dividends on!
These types of shares are like an interest-free loan to the company, and will not likely create any incentive or loyalty to the company for employees who understand the risks - and potential rewards- of working for a startup.
Takeaways:
- employees will want dividend rights that require dividends to be paid to them when dividends are paid to the controlling shareholders
- employees will want to be able to require the company to repurchase their shares
- employees will want to have the right to sell their shares at the same price as the controlling shareholders if a bid is made for the purchase of the company