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Introduction

Your startup is thriving but you still have more goodwill than cash, and you need to retain your talent. You can’t afford to raise their pay – what can you do? Many companies in this position “pay with shares”, that is, they offer options to their employees to purchase shares in the company in lieu of offering them a raise.

 

How Does this Work?

Employers can set up a detailed Employee Stock Option Plan (ESOP) if they expect to be giving options to several employees, and can create a separate class of shares for this purpose. If only one or two employees will be involved, a simple Stock Option Agreement can be used, however it is typical for the employer to also require the employee to sign a non-disclosure agreement (NDA) as a condition of the purchase of shares.

Under the ESOP or Stock Option Agreement, the employee is granted options to purchase shares, but will not become a shareholder until they exercise the option and purchase the shares. The employee will be offered a fixed number of options that will ‘vest’ according to a timetable eg. ⅓ of the options on January 30 for each of the next three years. The plan or agreement will usually provide that If the employee does not exercise the options, the options will expire on a fixed date, often 3 to 5 years after they were granted.

 

What Type of Shares Should be Available for Employees?

There is no ‘one size fits all’ answer to this question. The answer depends upon the unique share structure of the company and the reason for offering shares to the employee. Three basic rights can be attached to shares, but not all shares need to have all three rights. These rights are voting; dividends; and sharing in the proceeds of the liquidation of the company.

 

Most employers do not want employee shareholders to alter the balance of voting rights in a private company. The solution is to either offer employees shares without voting rights, or require them to enter into a voting trust agreement as a condition of exercising the option. Under  a voting trust the votes attached to the shares would be exercised by a trustee nominated by the company.startup

 

Employers are also often concerned about maintaining flexibility in their share structure so that future financings are possible and won’t be blocked by the existence of employee shareholders.

This flexibility can be maintained by providing a mechanism for the company to buy back the shares under certain conditions.

 

If the purpose of employee stock option plans are to give employees an incentive to maximize the value of the company, giving employees the opportunity to participate in the growth of the future value of the company is important. This can be accomplished by granting them options for shares that have the right to participate in the liquidation of the company, or which have the right to be included in any offer to purchase the company.

 

Of course, the particular combination of rights suitable for your company will depend on many factors. Your accountant and lawyer will be able to advise you on how best to use your corporate structure to ‘pay with shares’.

 

Takeaways:

  • stock option plans/agreements can be used to reward or incentivize employees when cash is tight
  • the rights attached to ‘employee shares’ should match the objectives of the stock option plan and should be designed to maintain flexibility for future company financing

 

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This article is provided for informational purposes only and does not create a lawyer-client relationship with the reader. It is not legal advice and should not be regarded as such. Any reliance on the information is solely at the reader’s own risk. Clausehound.com is a legal tool geared towards entrepreneurs, early-stage businesses and small businesses alike to help draft legal documents to make businesses more productive. Clausehound offers a $10 per month DIY Legal Library which hosts tens of thousands of legal clauses, contracts, articles, lawyer commentaries and instructional videos. Find Clausehound.com where you see this logo.

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