Share Options

May 28, 2017

Written by Narda Ben Zvi, Adv., Partner and Head of High tech and IP department at Yaacov Salomon, Lipschutz & Co.

 

Options are a tool companies may use to reward and incentivize people related to the company, including employees, officers and directors, as well as external advisors, consultants and even service-providers.

 

An option is a contract allowing the grantee to receive shares of the company under certain conditions and on certain dates, for payment of the indicated price, which may be the par value of the shares or a higher number. Such options serve to link the grantee's welfare with the company's success, their value (hopefully) climbing accordingly.

 

Grant of options to company shares is a vital tool of startup companies who wish to attract and retain the services of top notch employees, especially given that most startup companies are cash-poor, and frequently cannot pay competitive salaries.

 

The particular advantage of this tool in retaining the services of quality employees for many years lies in the vesting mechanism of options, which grants the company a hold on the heart of an employee, as the right to exchange a particular percentage of the awarded options for company shares becomes due, or vested, at intervals indicated in the grant agreement – and such award only takes place if the grantee is employed at such time, with termination of employment resulting in the lapse of all unvested options.

 

The period and intervals of option vesting and any "cliff", the minimal employment time before vesting begins, upon which a significant percentage (typically a third or fourth) of the options become vested, should be carefully considered to balance the award with the period for which the company would require the services of the grantee.

 

Options are a particularly popular award in the high-tech industry, and not merely due to monetary considerations. Options embody the hi-tech spirit, the dream of a successful exit, and thus constitute a particularly appropriate incentive in this field.

 

In fact, the grant of options is such a common practice that investors in hi-tech companies require that a pool of options be specifically kept for such grants, and frequently require to dilute only the company's founders and existing shareholders with such grants.

 

Employee options are almost invariably granted under a share option plan which is structured to comply with the requirements of a "trustee capital gains" track under section 102 of the Income Tax Ordinance. The purpose of this mechanism is to defer any tax due for the award of options, until the sale of the shares underlying the options, as ordinarily, any income or benefit derived from an employment relationship by an employee is subject to income tax.

 

According to such plans, which require formal approval by the Tax Authority, an employee's profit is considered capital gains (rather than being subject to ordinary income tax), allowing employees to benefit from more favorable tax treatment. Establishing an option plan under section 102  of the Income Tax Ordinance require the engagement of an Israeli trustee and the deposit of the shares with or under the supervision of the trustee for a two years' holding period, for the capital gains track. Non-employees, such as outside consultants, are subject to ordinary income tax.  

 

As options are perceived as a tool to compensate the employees but not to allow them to take part in the management of the Company, share option plans almost invariably have the grantees provide a proxy to the company's CEO or a person appointed by the board of directors for their shares, once exercised. Such proxy is also generally required by investors, who prefer to deal with a limited number of shareholders.

 

For employees, the disadvantages of options are the long vesting times and the trust period of two years required by the Israeli Income Tax in order to defer and minimize their tax liability, which require them to remain employed by the company in order to vest and be able to exercise their options and receive their shares, and the lack of market and liquidity for a private company's options.

 

A share option plan should clearly state that grant of options does not constitute any guarantee or implied promise of continued relationship with the company, and forbid the transfer of options other than by law of descent, as transferred options no longer offer an employee any incentive.

 

The practice of option grants to employees has become the expected norm in hi-tech companies, though the actual adoption of a share option plan is usually delayed until the startup company receives an investment, to defer even such minor expenses.

 

In employment agreements under which options are granted, they should be granted under the terms of the company's option plan, as shall be adopted by the board at its discretion. Given the weight of expectation and the standards of practice, it is rare for the adoption of such a plan to be unduly delayed, and such a delay may be beneficial for the company, to avoid granting options to early drop-outs who would otherwise have been entitled to shares of the company.

 

Before the founders engage employees whose services are vital to the company, they would be well-served by consulting with the company's lawyer regarding option grants and adoption of an option plan, prior to receiving queries from such employees.

 

Written by Narda Ben Zvi, Adv., Partner and Head of High tech and IP department at Yaacov Salomon, Lipschutz & Co.

 

 

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