Share Options vs Share Vesting
By Mathilde Chator, Last updated: 2021-06-03 (originally published on 2019-08-21)
Share Options vs Share Vesting
In a nutshell
1st step – The board of directors of a company will grant share options to key employees (beneficiaries of an Employee Share Option Plan or ESOP).
2nd step – The exercise of those share options is conditional upon the completion of pre-set conditions.
3rd step – Share vesting happens upon completion of all pre-set conditions: new shares are allotted or existing shares are transferred to the beneficiaries.
Share options are meant to create incentives for the key/senior employees or executives (directors) to stay in the company and increase profitability. Employees holding share options will be motivated in increasing the value of their shares and will eventually enable long-term value creation. A share option plan ultimately aligns the interests of the employees with those of the shareholders and the management, creating a shared stake in the company’s results. It represents a significant step forward on a company’s path towards better corporate governance.
The detailed terms of a share option plan cannot be drawn up without a clear understanding of the basic option terms. The summary below will provide some guidance towards the mechanisms of a share option scheme, where options are granted by a private company limited by shares.
A share option gives an employee the right to access the share capital of the company in the future. When an employee owns a share option, it is crucial to bear in mind that he/she does not own any share in the company yet. The mechanism of a share option is similar to that of a call option as it gives its holder the right to buy shares at a pre-determined price only if certain conditions are met. An option is a right and not an obligation, which means that the employee cannot be forced to purchase the shares. On the other hand, by granting share options to an employee, the company undertakes to issue the said shares upon satisfaction of the pre-determined conditions and exercise of the options by the employee.
What does a company actually grant when granting share options?
- A share option gives conditional access to one or several share(s) of the company.
- A share option does not grant the employee with any of the rights attached to shares, which means that the employee is not entitled to participate in the general meetings nor to receive dividends until the shares are effectively allotted.
- Share options are generally granted for free.
- Share options can generally not be transferred nor sold to other persons by the grantee.
As a share option plan is generally conditional upon the employee satisfying a number of pre-set conditions or upon the occurrence of pre-set events, the share vesting is the acquisition of the actual right to exercise the options.
How to establish a conditional share option scheme
- Set a timeline: the share options are exercisable over a vesting period, meaning that a portion of the options can be exercised periodically, for instance at each anniversary of the date of the share option plan (the “Vesting Date”) and during a pre-determined exercise period. Without a vesting period, the employee may be tempted to exercise all options at once, sell them when most profitable and leave the company. An accelerated vesting can be provided for in case of events such as a change of control or the IPO of the company, which will render the options immediately exercisable. The exercise period is the window during which the grantee can purchase the vested shares from the company.
- Lay down preconditions: depending on the company’s shareholding structure, the employee may be required to adhere to the existing or to enter into a new shareholders’ agreement or put and call agreement, setting out conditions for the transfer of the shares held by the employee as a result of the exercise of the options.
- Lay down vesting conditions:
- set performance conditions: quantifiable key performance indicators (KPIs) such as the company’s EBIT, turnover, sales, new customers, share market value, etc. which can be influenced by the grantee’s actions;
- set the relevant period for assessment of performance conditions;
- define whether the grantee shall be an employee or director of the company at each Vesting Date.
The satisfaction of the performance conditions is assessed on or after each Vesting Date by a company body (generally the board of directors). Upon satisfaction of these conditions, the options may be exercisable in whole only, or it may be provided that the employee can exercise the options in part depending on the percentage of conditions effectively achieved.
- Determine the exercise price: the exercise of the options can be at nil cost or for an exercise price pre-determined at the time of formation of the share option plan. The exercise price is generally based on the market value of the shares at the time of formation of the plan, regardless of the market price of the shares at the exercise date.
- Set lapse and cancellation conditions: the options usually lapse and terminate in case of termination of employment, death of the employee, insolvency of the company, etc.
If the employee satisfies all conditions set out by the share option plan, the next step is to deliver an application form to the company to request the issue of the vested shares (a template application form can be appended to the share option plan to ease the exercise of the options). A resolution of the directors will then be passed to approve the allotment of the shares.
Once the shares are issued and allocated, the grantee becomes a shareholder of the company. Except otherwise provided for in the share option scheme, the employee acquires the same rights as existing shareholders of the company, i.e. voting rights at general meetings of the company, right to dividends, right to transfer the shares, etc.
Checklist of vesting conditions for an employee
Mathilde Chator is an Associate at SLOTINE, the Hong Kong Solicitor’s firm specialising in cross-border business law. Her main areas of practice are M&A, International Investments, Private Equity and Corporate Governance.
SLOTINE is one of Zegal’s Managed Plan partners and offers tailored solutions combining document drafting access and legal services. Find out more about the SLOTINE Managed Accounts plan here.
This article does not constitute legal advice.