Share option agreements

Share option agreements are legally binding documents that define precisely how and when employees can acquire company shares. Strategic drafting is essential as these agreements establish rights, obligations, and protections for both parties.

Key variables in share option agreements

The drafting of share option agreements allows for significant flexibility, regardless of the underlying scheme type, including

• Vesting Triggers - options may vest based on time-served, performance targets, or a combination of both

• Performance Metrics - can be linked to individual, team, departmental, or company-wide KPIs

• Accelerated Vesting - conditions under which vesting timelines might be shortened

• Exercise Price - can be set at market value, nominal value, or with discounts (subject to tax implications)

• Valuation Methodology - different approaches to company valuation affect option value

• Settlement Mechanisms - cash settlement vs. actual share issuance options

• Option Term Length - typically between 5-10 years, but can be customised

• Vesting Schedules - linear, cliff, or back-loaded structures

• Exercise Windows - can be limited to specific periods or continuously available

• Change of Control Provisions - treatment of unvested options during acquisitions

• Drag-Along Rights - requirements to sell shares during specific transactions

• Leaver Definitions - customisable definitions of good/bad/intermediate leaver categories

• Notice Period Treatment - how options are treated during notice periods

• Post-Termination Exercise Periods - can range from 30 days to several years

Scheme specific clauses

Certain clauses in option agreements must be tailored to the specific scheme type:

• Tax Clauses - each type of share scheme type requires specific tax covenant wording to ensure compliance with HMRC requirements

• Exercise Procedures - approved schemes have stricter requirements regarding when and how options can be exercised

• Disqualifying Events - tax-advantaged schemes must include specific provisions outlining events that could disqualify tax benefits

• Scheme Limits - clauses specifying individual and company-wide limits vary by scheme type

• Compliance Reporting - different notification requirements to HMRC necessitate varied reporting clauses

Key Clauses in Share Option Agreements

• Grant and Vesting Provisions - should clearly specify the number of options granted, the exercise price, and the grant date. Vesting provisions outline the schedule by which options become exercisable, typically over a set period or based on performance conditions.

• Exercise Conditions - how and when options can be exercised, including any notice requirements, payment methods, and time limitations. These conditions may also specify circumstances under which early exercise is permitted, such as a change in control of the company.

• Leaver Provisions - crucial as determine what happens to options when an employee leaves the company. These typically distinguish between "good leavers" (e.g., retirement, redundancy, ill health) and "bad leavers" (e.g., resignation, dismissal for cause). Good leavers might retain some or all of their vested options for a specified period, while bad leavers often forfeit all options, including those already vested.

• Change of Control Provisions - specify what happens to options in the event of a merger, acquisition, or other significant corporate transaction. These provisions may accelerate vesting, require option holders to exercise or sell their options, or provide for the replacement of options with equivalent rights in the acquiring company.

• Adjustment Provisions - how options will be treated in the event of corporate actions such as stock splits, rights issues, or dividends. These provisions ensure that option holders are neither advantaged nor disadvantaged by such events.

• Malus and Clawback - For senior executives particularly, include provisions that allow the company to reduce unvested options (malus) in cases of misconduct or material misstatement and recover value from already exercised options (clawback) in similar circumstances

• Non-Transferability and Assignment - options are typically non-transferable and cannot be assigned or charged. These provisions ensure that options remain with the intended beneficiary and cannot be used as collateral or transferred to third parties.

Risks and tripwires for employees

1. Tax Implications

Employees should be aware of potential tax liabilities when exercising options and selling shares. For unapproved schemes, income tax and National Insurance contributions may be due on exercise, creating a potential cash flow issue if the shares cannot be immediately sold to cover the tax liability.

2. Dilution

As new shares are issued through option exercises, existing shareholders' ownership percentages decrease. Employees should understand how dilution might affect the value of their options, particularly in companies that undergo multiple funding rounds.

3. Valuation Risks

For private companies, determining fair market value can be challenging and subjective. If HMRC disagrees with a valuation used for option grants, tax consequences could be severe, potentially negating expected tax advantages.

4. Illiquidity

For private companies, there may be no ready market for shares acquired through option exercises. Employees should understand any restrictions on selling shares and the potential timeframe for realizing value.

5. Forfeiture Risks

Employees need to clearly understand vesting conditions and leaver provisions to avoid unexpected forfeiture of options. Complex performance conditions may be difficult to track and verify, creating uncertainty about when options will vest.

6. Employer Manipulation

Employees should be aware of potential manipulation risks where employers might:

• Set unrealistic or subjective performance targets that are difficult to achieve

• Time corporate events to negatively impact option value before employee exercise

• Create circumstances that could trigger "bad leaver" provisions

• Adjust company valuation methods at critical junctures to influence option value

• Implement structural changes that technically preserve but practically diminish option value

How we can help

For Employers

• Scheme Design and Implementation - bespoke option schemes that align with your company's strategic objectives, corporate culture, and financial goals.

• Documentation Preparation - comprehensive scheme rules, option agreements, board resolutions, and shareholder approvals tailored to your specific requirements.

For Employees

• Independent Advice - impartial advice to employees who have been offered share options, explaining the potential benefits, risks, and tax implications in clear terms.

• Rights Assessment - we help employees understand their specific rights under the option agreement, including vesting conditions, exercise procedures, and leaver provisions.