A new job opportunity can be exciting, and it’s even more exciting when the offer comes with a promise of employee stock options or equity participation awards.
Sometimes smaller, entrepreneurial companies offer employee stock options or equity awards to make up for lower salaries, with the expectation the company will grow, and the value of the stock or equity will increase. Larger, more established businesses offer stock options or equity awards to executives and key employees, as an incentive to stay with the company and improve company performance.
But what do employee stock options and equity participation awards actually mean? These incentives can be legally complicated, and sometimes, their complications hide the fact that the options or awards aren’t worth very much. When assessing stock options or equity awards, here’s some important issues to focus on.
What are employee stock options?
A stock option means the right to purchase or acquire stock when certain conditions are met.
In stock options’ classic form, once you work a certain number of years, you obtain the right to exercise the option and purchase stock at a specified price. When you acquire the right to exercise the options, the options are said to “vest.” If the stock gained value in the meantime, you could sell the stock and keep the difference between the option price and the sale price.
This classic form is less common today, and employee stock options can be structured many other ways. Sometimes options will vest, but there will be strict contractual limits on how and when you exercise them. Even if you exercise your options and acquire the stock, there can be limits on how and when you can sell the stock, and your rights may be different from other shareholders.
What’s an equity participation agreement?
The term “equity” is generally used to refer to ownership interests in a business. For a corporation, ownership interests are typically called “stock”; but with a limited liability company (LLC), ownership interests are typically called “membership interests” or “membership units.” An “equity participation agreement” typically means an agreement that grants ownership interests when certain conditions are met. If your employer is an LLC, you may get “equity participation awards” instead of “stock options,” but the legal framework is similar.
What are profit interests and phantom stock?
Some agreements are confusingly labeled “equity participation agreements” but don’t really grant ownership interests at all. These agreements may pay bonuses or incentives based on stock price, company value, or company earnings—but the agreements don’t grant you the right to purchase or acquire equity. These bonuses and incentives are sometimes called “profit interests” or “phantom stock.” Depending on how your company performs, they can still be worthwhile, but don’t be misled into thinking you’ll get stock or ownership in the company.
What does it mean for employee stock options or equity participation to vest?
Very generally, when a stock option or equity participation award “vests” or is “vested,” it means specified conditions are satisfied and you can buy or acquire the stock or equity. But vesting can have very different consequences under different types of stock option and equity participation plans.
For example, imagine a stock option plan that awards 20 shares every year you are employed, up to 100 shares after five years’ employment. Some employee stock option plans will say that 20% of your options “vest” each year, but will also say you can’t exercise the options until they’re “fully vested”—meaning that until you’ve worked all five years and acquired 100% of the options, you really don’t have the right to exercise your options at all. There can also be terms that change or accelerate whether options have vested.
Vesting can also have a narrowly defined contractual meaning. Even if you acquire stock or equity, you may not have the right to immediately sell it, or you are only allowed to sell under very narrowly defined circumstances. For instance, some agreements condition your right to sell on a “change of control,” which usually means an outside group will acquire or buy out the company. You may also be required to sell at a specified price or to specified buyers. The stricter these restrictions are, the less likely you’ll benefit from your stock or equity.
What if my employment ends?
The main reason employers offer stock options and equity awards is to encourage employees to stay with the company and do their best work. So stock option and equity participation plans typically provide that, if you quit or are terminated for cause, you don’t get to keep stock options or equity participation rights. Under some plans, even if your stock options or equity awards previously vested, these rights are permanently lost. And under some plans, previously awarded stock or equity can even be taken away from you.
Your rights ultimately depend on the specific terms of your stock option or equity participation plan. Some plans distinguish between terminations “for cause” and “without cause”: if you’re laid off or terminated without cause, you may be able to keep your equity or cash it out. There may also be terms governing special circumstances like retirement or a company buyout.
What are my employee stock options or equity participation awards worth?
In their classic form, when employee stock options vested, the holder had the right to purchase the stock at a specific price. If the stock gained value during the period from grant to vesting, the recipient could sell the stock and keep the profit. Some publicly traded companies still follow this model. If you exercise your stock options and are awarded common, publicly traded stock, you may also be able to sell your stock through a broker. But if your employer is a startup, or if your employer is not a publicly traded company, there can be strict limits on your right to sell and on the selling price.
Watch out for contractually defined “classes” of stock or equity, one for investors and another for employees. In the event of a company buyout, investors typically get priority over the employees. This can mean investors are paid first, or they’re paid at a premium, before employees can redeem their stock or equity. Be especially cautious with plans that discount the value of your stock or equity based on “financial sponsor base value,” “multiple on invested capital” (MOIC), or “invested rate of return” (IRR): these discounts favor investors, making it less likely you get anything for your equity.
Contact Our Employee Benefit Lawyers
Baillon Thome Jozwiak & Wanta LLP is dedicated to protecting the rights of employees in the Twin Cities area and throughout Minnesota. If you have questions about your rights under stock option plans or equity participation agreements, our employee benefit lawyers can help. Contact us for a free initial consultation.