How to draft an option agreement: a detailed guide, recommendations, and advice

Preparing a well-thought-out option programme and option agreements is a key element for a company to grant options to employees without concern and to avoid possible future ambiguities or disputes. In this article, we will explain the key aspects to consider when drafting an option plan and option agreements. As the specific terms of an option agreement depend on the needs of the particular company, specific terms will vary from case to case, but there are established best practices that can always be followed.

Why grant options?

A successful entrepreneur knows that motivating employees is crucial to improving the company’s financial performance and internal climate. One of the ways to motivate employees is to involve them in the company’s shareholding by granting them employee stock options. Under an option agreement, an option gives the employee the right, but not the obligation, to receive some future benefit under agreed terms. Such a benefit is usually a shareholding in the company or a sum of money. For the company, granting options is also useful because if employees are motivated to continue working for the employer in order to vest the option, it reduces labour turnover.

The option programme underlying the option agreements

An option programme is an internal agreement of the company that defines the principles for granting options. The creation of an option programme is not mandatory for granting options, but it helps to provide a framework within which the company will grant options to employees in the future. The essence of an option programme is agreed either in the company’s founders’ agreement or shareholders’ agreement, which sets out the option pool, i.e. the maximum amount of underlying assets (share capital) that the company may grant to employees. The option pool is typically set at an absolute value (e.g. up to EUR 1 000 of share capital).

The option programme also determines other policies for granting options, such as whether options are granted only to employees or also to members of the management board or other service providers, e.g. natural persons providing services under a services agreement. The option programme also typically sets out the vesting policy, e.g. vesting period, cliff and acceleration. If these terms confuse you, you can refer to our start-up glossary.

If the company has an option programme, options must be granted in accordance with the terms of the option programme. In such a case, options can only be granted on terms that differ from the option programme if a resolution to that effect is passed by the shareholders. If the needs of the company change and the initially agreed option pool proves to be too small or the terms of the option programme need to be amended, the option programme may be amended by agreement of the shareholders.

Size of share capital in the context of an option pool

When setting up an option programme and granting options, it is recommended to also take into account the size of the company’s share capital. From 1 February 2023, a limited liability company with a share capital of only one cent may be established in Estonia. When setting up an option pool, however, it is recommended that the share capital of the company should be at least EUR 100, which can be divided into 10 000 shares (if the smallest denomination of a share is one cent). The smaller the share capital, the smaller the option pool and a small option pool might not be enough to grant options to all employees. A small option pool will also be unreasonably large in percentage terms, and the shareholding under the option agreement will be unusually large. In addition, there are other reasons why it is not wise to set up a company with a share capital of one cent, which can be read about in more detail here.

How is an option pool reflected in share capital?

Below we explain the three most common option pool models and the pros and cons to consider when setting up an option pool:

1. Virtual stock options

With virtual stock options, the option pool exists only in an ‘excel table’ and the option pool is not entered in the commercial register. Thus, there is no specific shareholder in the company’s shareholder structure who would temporarily hold the option pool and transfer a share of the company to the option holders. It is only when the employee exercises their option that the shareholders increase the share capital of the company and the employee acquires a share in the company.

2. Own share as an option pool

If the option pool is established as the company’s own share, the option pool is in the share capital of the company. The company holds the option pool temporarily and, on exercising the option, the company transfers to the employee the portion of the share that the employee is entitled to acquire on vesting of the option. However, such an option pool model has to take into account the restrictions arising from Section 162 of the Commercial Code, e.g. the nominal value of the share held by the limited liability company may not exceed 1/3 of the share capital.

3. Option pool held by a shareholder

If the option pool is held by a shareholder, the option pool is part of the share capital of the company, but the shareholder temporarily acquires the corresponding share instead of the company. On exercise of the option, the shareholder transfers to the employee the share which they are entitled to acquire on vesting of the option. This type of option pool structure is not very common, but it does occasionally occur in practice.

Key terms of an option agreement

The following are the key terms of an option agreement that need to be considered for each option agreement. Some terms are dictated by the option programme, in which case compliance with the option programme must be ensured.

1. Vesting an option

The option agreement sets out the conditions for vesting the option and the vesting period. In Estonia, the common vesting period in practice is four years, but it may be shorter or longer. From a tax point of view, it is useful to set a vesting period of not less than three years. You can read more about the taxation of options here.

Vesting an option is often subject to a condition that the option is not vested before the expiry of a certain period (cliff). This means that the option holder does not vest any part of the option, e.g. during the first year of the option period, but after the cliff, the option holder immediately vests 25% of the option. The use of a cliff ensures that the employee who is hired does not immediately commence vesting their option. In this way, the employer can assess the employee’s performance in the first year of employment and, if the agreement is terminated, the employee is not entitled to exercise the option because they have not vested any part of it. However, it is also common for the option to vest in equal monthly instalments.

The option agreement may also provide for accelerated vesting rules, but the tax consequences of accelerated vesting must always be taken into account, as well as the importance of the option holder to the activities of the company.

2. Exercise price

One of the key terms in an option agreement is the exercise price. This is the amount of money the option holder must pay to acquire the share. The price is set at the time the option agreement is concluded and is usually favourable to the option holder. The appeal of an option is that in the future, when the value of the company has risen, the option holder can become a shareholder at significantly more favourable terms than the market price.

The exercise price of an option may but does not need to be equal to the nominal value of the underlying share. Because the exercise of an option gives the option holder a substantially more favourable acquisition price than market conditions, the exercise of an option is in some cases treated as a fringe benefit.

Termination of employment relationship and option

In an option agreement, the terms ‘good leaver’, ‘bad leaver’ and ‘voluntary leaver’ are also typically used to describe the circumstances in which an employee leaves the company and the effect of that departure on the vesting and exercise of an option. These conditions can have a significant impact on the treatment of option vesting when the employment relationship is terminated.

1. Good leaver

A good leaver is usually an employee who leaves the company on terms that the company considers favourable or acceptable. This could be retirement, redundancy, death or disability. The specific criteria for good leavers vary from company to company and are usually defined in the option agreement.

A good leaver is often granted more favourable conditions for the vesting of options. They may be allowed to retain vested options for a longer period after leaving, or even have the vesting of their unvested portion of the option accelerated and vest after the employee leaves. The aim is to recognise the employee’s positive contribution to the company despite the employee’s departure.

2. Bad leaver

A ‘bad leaver’ is an employee who leaves the company under unfavourable circumstances, such as an extraordinary termination of employment (dismissal) by the employer, if the employee leaves in a manner not approved by the company, or if the employee has caused damage to the company. The criteria for qualifying a bad leaver are also company-specific and set out in option agreements.

Bad leavers may face harsher consequences in terms of options. Typically, they may lose the right to exercise vested options or lose both vested and unvested options. The purpose of this clause is to create a consequence for the employer in the event of an employee leaving under adverse circumstances and to discourage behaviour that is not in the best interests of the company.

3. Voluntary Leaver

A voluntary leaver is an employee who decides to leave employment of their own volition, other than under good leaver conditions (e.g. retirement, redundancy or other circumstances beyond the control of the employee). This category is broader and can include personal or professional reasons for leaving.

The treatment of options for voluntary leavers may be different. Some companies may treat voluntary leavers in the same way as good leavers, allowing them to exercise vested options. In other cases, voluntary leavers may be subject to stricter conditions, depending on the circumstances of the departure and the employee’s role or contributions to the company. For example, an employee may lose the right to exercise a percentage of vested options. The details depend on the option programme and the terms of the option agreement.

Conditions for exercising an option

The option agreement sets out the conditions for exercising the option. Exercising an option refers to the act whereby the option holder acquires a share in the company at a predetermined price, known as the exercise or sale price. Typically, an employee becomes entitled to exercise an option:

  • On the exit or liquidation of the company;
  • On the expiry of a specified period after the grant of the option;
  • Upon the death of the option holder.

1. Activities of the company in exercising the option

Depending on the option programme, exercising an option requires either an increase in share capital (virtual stock options) or transferring a share of the company to the employee.

In the case of an increase in share capital, it is important that the option programme (e.g. the founders’ or shareholders’ agreement) stipulates that the shareholders must take the necessary steps to increase the share capital, e.g. adopt a shareholders’ resolution. Otherwise, the employee may have the right to exercise the option under the option agreement, but cannot exercise it in practice, as the shareholders are not obliged to increase the share capital and issue a new share to the employee.

In the case of a transfer of a share to an employee (option pool held by the company or a shareholder), the formal requirements of the share transfer transaction must be taken into account. As a general rule, the share sale transaction must be notarised. The notarial form requirement can be waived if the share capital of the company is at least EUR 10 000 and the articles of association permit the transfer of the share in a form that can be reproduced in writing.

It is advisable to conclude option agreements with several persons simultaneously. In this case, if each employee vests their option, each of them can exercise their option at the same time, which facilitates the increase of the share capital (the shareholders do not have to make several separate resolutions) or the transfer (less time and money spent at the notary or, if the notarial form requirement is waived, less hassle in carrying out the transactions).

2. Cash settlement of an option

The question often arises as to whether an employee can be compensated in cash for an option, or whether the employee can be obliged to sell back their shareholding, etc. In principle, there is no prohibition on writing such restrictions into the option agreement or the option programme. However, such restrictions may have tax implications.

If, at the time of granting the option, it is known in advance that the employee will not be able to acquire the shareholding under the option agreement but will be compensated in cash for the value of the shareholding, this is a phantom stock situation. When the employee is compensated for the value of the option, the payment to the employee is taxed as a normal bonus (for income and social tax purposes), even if the option is exercised after 3 years from the start of the vesting period.

If the employee acquires the share and sells it back to the employer, even on the next day, all the conditions are formally met, the acquisition is tax-free, and so is the sale of the acquired share. In this case, the sale of the share is taxable according to the rules for the normal sale of assets, also taking into account the expenses incurred in the exercise of the option.

The law provides for an exception where 100% of the shares of the company are sold (full exit) before the options have been exercised. In this case, paying a cash settlement for the value of the option is allowed, but the 3-year proportion of the holding of the option must be taken into account. For example, if the full exit takes place 2 years after granting the option, the employee will receive 2/3 of the sum tax-free, whereas the sum for the unvested proportion will be taxable.

Need help drafting an option agreement?

The experts at Hedman Law Firm are here to provide you with expert advice and ensure that your agreement is legally binding and meets your needs. Contact us today to discuss how we can help you.

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