How employee stock options work and what conditions are important — a column by REVERA

Legal experts Nikolay Gorelik and Ekaterina Yakoltsevich from the legal company REVERA explained the mechanics of stock options and the possible conditions of stock option programs in their column on App2Top.

Source of the illustration — Freepik

Nikolay Gorelik and Ekaterina Yakoltsevich

The trend of issuing stock options to employees was set by the well-known (even clichéd) success story of Google employees. Instead of a high salary, these lucky individuals received options and became millionaires after Google's IPO. It was a win-win story where founders managed to reduce initial costs, and employees gained significantly more over time, although they assumed a certain level of risk.

While this was novel at the time, nowadays, issuing options to employees is considered a best practice for IT companies. From our experience, even young gaming studios implement stock option programs for their employees. Often, implementing an option program is a requirement of investors to be fulfilled after closing a deal.

Before we proceed, let's define some terms. Employee stock options, stock option programs, stock option plans, and ESOP are synonymous terms for a widely recognized phenomenon in the IT industry. Simply put, a stock option program is a set of rules to motivate company employees by granting them rights to company shares.

So, let's dive into the mechanics of how stock options work and the steps necessary to launch an option program in your company. Step by step, options and their implementation in a company look as follows:

Stage 1. Implementing a Stock Option Program

Many companies, especially at the startup stage, neglect this step and do not formalize the stock option program legally—they just give employees stock options without contracts (essentially just a verbal promise). This often leads to disputes and employee dissatisfaction when they receive nothing or something completely different from what they expected.

Therefore, the implementation of a stock option program and its legal formalization is a crucial step that should precede granting options to employees. Typically, at this stage, the necessary corporate approvals are obtained, a specific class of shares may be designated, and the rules of the stock option program are approved (who gets the option on shares, how many shares will be allocated to options (the so-called option pool), what the vesting period is, what rights the employee will have, what rights the future shareholder will have, and what rights the participants will have regarding the disposition of their shares/options on the shares).

Stage 2. Selecting Participants for Stock Option Programs

The second stage involves selecting the employee who will receive an option and concluding a stock option agreement with this employee. If the stock option program outlines general option issuance rules applicable to all employees, the option agreement specifies particular conditions for an individual employee. These conditions might include, among other things, KPIs, the number of shares, the vesting period (including the presence of a cliff).

Startup founders typically do not set criteria for employees to whom options will be granted because the staff in startups is small, making it easy to identify the right employees. However, as the company grows, founders prefer to set criteria for such employees, for example:

• work experience;
• the specific employee's position or role (e.g., departmental heads);
• the particular employee's achievements (e.g., achieving KPIs);
• candidate approval by the company's internal governing body (e.g., approval by the board of directors).

Stage 3. The Process Begins, Soon (or Not So Soon), the Employee Becomes a Shareholder

Since an option implies that the employee will accumulate rights to shares while working at the company, option agreements include conditions such as cliff and vesting. For clarity, let's explain these concepts.

Vesting is the period during which shares are allocated to an employee. The employee can purchase the allocated shares gradually as they are vested or at the end of the entire vesting period.

In addition to vesting, companies use the concept of a cliff. A cliff is a period after signing the agreement during which no shares are vested to the employee. Typically, this period equals one year and is set to prevent share dilution in cases when an employee quits immediately after being given an option. A cliff is not a mandatory condition in a stock option program, so it may be applied to all employees, to select employees, or not set at all.

The employee can purchase accrued shares gradually as they are vested or at the end of the vesting period.

The vesting period can vary, but companies typically use the following option: a 4-year vesting period, including a 1-year cliff. This means the first part of the shares will be allocated to the employee only after the cliff expires, and then shares will be gradually vested over three years.

As for the frequency of share allocation, companies have various options: monthly, quarterly, biannually, or annually.

The vesting schedule might be as follows:

1. Standard – shares are vested in equal parts with specific regularity. For instance, 10 shares in the first year, 10 in the second, 10 in the third, etc.
2. Back-loaded – shares are vested in increasing progression. For instance, 10 shares in the first year, 20 in the second, 30 in the third, etc.
3. Performance-based vesting – shares are vested only if certain KPIs are met. For example, meeting a revenue plan or completing game development in the first year—shares will be vested if the employee achieves specified KPIs.

Some companies use this type of vesting for all employees and for all shares an employee can receive by option. However, it's considered more equitable to apply performance-based vesting to top managers and those in leadership roles, as they're more significantly involved in achieving KPIs. It's also recommended to use this vesting type for only a portion of the shares since there are objective factors that are beyond the employee's control but can impact KPI achievement.

4. Accelerated – shares are vested in full upon a triggering event. It’s common for stock option plans to include a condition where, upon a company's IPO or full sale, all shares specified in the agreement are vested to the employee.

Stage 4. Exercising the Option or "Hooray, I Became a Shareholder!"

After the end of the vesting period or upon occurrence of certain events (e.g., termination of employment), the employee has the right to buy their vested shares. Purchasing the shares marks the exercise of the employee’s option. Exercising the option involves paying for the shares and registering the employee as a company shareholder. From the moment of exercising the option, the employee becomes a shareholder and acquires all the privileges and restrictions imposed by the company's charter or shareholders' agreement (if any).

Here, we’ll address the question of what rights associated with the shares the employee will gain upon exercising the option. A common practice is to allocate a separate class of shares for options and to impose restrictions on such shares. These restrictions are divided into two groups:

1) Voting – employees may receive voting or non-voting shares. The difference is that employees with non-voting shares do not have the right to vote at shareholders’ meetings, thus, their shares are not counted in decision-making. It is important to analyze whether local legislation allows the issuance of non-voting shares and to act accordingly.

2) Transfer restrictions – given that the company’s shareholders form a closed circle of like-minded individuals, founders and investors are usually reluctant to admit "outsiders" into this group. To prevent such individuals from becoming shareholders, option agreements, the charter, or shareholders’ agreement provide certain tools:

• the preemptive right of other shareholders to purchase, where the employee first offers the shares to current shareholders before selling to a third party;
• lock-up, or a ban on selling the shares for a certain period;
• requiring the approval of any sale by other shareholders;
• other restrictions (e.g., a restriction on sale within 6 months post-IPO).

Additionally, there are often situations where an employee, after obtaining shares, leaves the company, and the ESOP specifies conditions regarding the fate of these shares post-departure.

Some companies impose a rather strict condition on employees, stipulating that leaving the company results in the employee losing their shares, which must be sold back to the company or other shareholders. However, this practice is increasingly rare, as is the practice of allowing the employee to retain all shares regardless of the reason for leaving. The most common approach is to tie the fate of the shares to various scenarios of employee departure, employing the terms “good leaver” and “bad leaver.” For example, an employee is considered a “bad leaver” if dismissed for misconduct, theft, NDA breach, failing to meet KPIs, or contract violation. In such cases, the employee must sell their shares back to the company or other shareholders (often at nominal value). In all other cases, the employee is considered a “good leaver” and retains the shares after leaving.

Stage 5. The Long-Awaited Exit

The final and most rewarding stage for the employee is the fifth one. This stage occurs when the company reaches an exit. An exit may involve a change of control in the company, an IPO, a full sale of all company shares, or other events. During this stage, the employee, having purchased shares at a lower price, can sell them at a higher price and profit from the sale.

In conclusion, after passing through these five stages, everyone will be happy: the company, which throughout the option term and up to the exit had a team driven by common success, and the employees, who received a part of the shared success.