A stock option agreement is a contract which entitles its holder, who is typically an employee to buy the stocks of his employer company at the price at which they were trading at the time the options were offered. It has to be noted here that such a contract only confers the right and not an obligation upon its holder to buy shares at a pre-agreed price. This incentivizes the employees to work hard and with commitment to the organization. Stock options are typically, for a fixed period of time. For example, A gets 1000 stocks of his employer company and he can sell them over a period of 5 years at a pre-determined price.
Purpose of An Option Agreement
An option contract allows an employee to buy shares of the employer company and sell them at a pre-determined price. It allows the employee to share part-ownership of the company. It enables them to feel a part of the decision-making process and gets them personally interested in the performance of the company. If the company performs well, the employees get rewarded in the form of higher stock prices.
Inclusions in An Option Agreement
Apart from complex commercial and technical clauses such as vesting, eligibility, pricing formulae etc. certain standard boilerplate clauses such as dispute resolution, choice of law, severability, entire agreement, waiver and remedies need to be mentioned in the contract.
Key terms of An Option Agreement
Key terms of a stock option agreement are:
- Eligibility Criteria: Typically, such a contract contains a list of conditions which would make the employees eligible for the stock options. Performance levels may be associated with such eligibility.
- Vesting: The time when such options get vested in employees also needs to be included in the contract. For example, a lot of companies offer stock options only to higher level employees.
- Process of grant: The entire process of how the stock options are granted to the employees is typically included in the contract. Exercise: The mechanism through which an employee may exercise his stock option should also be mentioned.
- Pricing formulae: The formulae to arrive at a pre-determined price should also be mentioned in order to avoid future disputes.
- Forfeiture: Any misconduct or other default event which makes the employee ineligible to be granted the stock option should also be mentioned in the agreement.
Drafting of An Option Agreement
A stock option template can be drafted effectively by following the below given guidelines:
- The eligibility criteria should be drafted carefully and a narrow set of employees should be covered within. The company should make sure to balance the incentivisation with mitigation of losses.
- The benefits which may accrue to the employees, if they are granted stock options should be adequately explained.
- The consequences of forfeiture, whom should the stock option be granted to in such an event must be mentioned.
- A clause which devolves the share on the surviving spouse in the event of death should also be included.
- Vesting events should be drafted carefully. This clause should include the time and manner of vesting.
- The language used should be simple and direct.
- What happens to the stock options, of the company gets acquired, should also be addressed.
- Clause stating that if not exercised stock options shall expire after the efflux of the term of the agreement, should be included.
Types of An Option Agreement
An option agreement or a stock option agreement is of two types:
- Non-qualified stock options: Non-qualified stock options do not qualify for any special tax treatment under the applicable laws.
- Incentive stock options: Incentive stock options offer greater tax benefits but also increase the risk of alternate minimum tax
Benefits of An Option Agreement
Benefits of a stock option agreement are:
- Increased monetary benefits.
- More incentives to work with greater commitment and dedication to the employer organization.
- Higher returns.
- Additional income over and above the fixed remuneration.
- Having obtained part-ownership of the company makes the employees take personal interest in its growth.
- Better job security and satisfaction to employees owing to the underlying monetary as well as non-monetary benefits.
- Tax-benefits accruing on a certain type of stock options.
Cons of An Option Agreement
Following are the cons of a stock option agreement:
- The pre-determined price might benefit the employee, but if the prices fall, then the employee may also suffer losses. Hence, conferring of stock options is a risky activity.
- Failure to exercise within a stipulated time period may also lead to expiration of this right.
- If the vesting criteria is very narrow, then a majority of employees may not be able to avail the benefits of the same.
A stock option agreement or an option agreement is a good way of giving incentives to the employees and encouraging growth and expansion of business. Moreover, greater subscription may also lead to increase in share prices. In the event of any dispute or breach of the contract, litigation or arbitration may be resorted to.
Sample Stock Option Agreement
A sample of the agreement can be downloaded from below.
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