For those of you who prefer this in Infographic format, see here.
The next part of the Due Diligence Handbook deals with options. This is an interesting area to review, but it is also a big one, and can be a bit technical. Seeing how most of you likely have neither the time nor the inclination to read a book at a single setting, I’ll be breaking this topic down into smaller chunks, some of which are quite small. At the end, I’ll put together a nice little directory and voila! You shall have some option guidance in nice, small, easily digestible portions. Rather like cupcakes! Just without the frosting. And the sugar content. And the chocolate. And the sprinkles.
But otherwise, identical! 🙂 And look, I’ve drawn you a lovely cupcake so you get the sugar, chocolate and sprinkles as well.
In any event, let’s start off with some basic terminology which feature heavily in the world of options. Where there is more than one term used to define the same thing, the alternate term will appear in parentheses. So you don’t have to skip around, as much as possible I’ve ordered these so that one definition leads to or is incorporated into subsequent ones, as opposed to alphabetical order. For certain larger or more complex items, I’ve included links to stand-alone articles.
Shares and Shareholders (Stock and Stockholders)
A share is an ownership unit of a company and the owners of said units are called “shareholders. While technically there are differences between “shares” and “stock”, in practice, the two terms are used interchangeably. In the US, “stock” seems to be more common. In the UK, “share” is favored (or should I say “favoured”). In Israel the “share” terminology is more common than the “stock” terminology, though both are used.
For consistency, I’m going to stick with share, share option and shareholder.
Share Options (Stock Options)
A share option, often referred to as simply an “option”, is the right, but not the obligation, to buy a share of a company. Generally, the ratio is 1:1, that is, each option gives the recipient the right to buy one share of the company.
An option grant is the issuance of options to a recipient, such as an employee or a consultant. The grant will generally be written up in a document called an option agreement. The option agreement outlines the terms of the options (e.g. vesting schedule, exercise price, etc.) as well as any rules and requirements relating to both the options and any resulting shares (e.g. all shares are subject to a proxy until an IPO, options are non-transferrable, etc.).
Vesting, Vesting Period, Vesting Schedule
Vesting is the process of earning the rights to the options, the vesting period is the time period over which these rights are earned and the vesting schedule is the rate at which vesting happens over the course of the vesting period. For a more detailed explanation, see here.
As noted above, an option gives you the right to buy a share; it doesn’t give you the share itself. To exercise an option is to exercise your right and buy the share. Bear in mind that you can generally only exercise the options that are vested, though some plans and situations may allow for exceptions. Second, in order to exercise your options, you will need to pay the….
Exercise price (Strike Price)
The exercise price is the price you will need to pay for each share when you exercise the option. This can be zero, in particular if the company is very new and hasn’t built up any value yet. Generally the exercise price will be a set amount (e.g. $0.20 per share) but it may also be a formula, or a value to be set dependent on some future event or factor.
Issuance date (Date of Option Grant)
The issuance date is the date that the Company officially made the option grant. While this will vary from country to country and company to company, where option grants require approval by the Board of Directors, the issuance date will generally be the date that the Board officially approved the grant.
The option life is the time period that the options are good for. Once the option life ends, the option expires and the right or ability to exercise the option and buy the share is lost. Option lives tend to be ten years, though this varies. In addition, the option life will generally end (early) if you leave the company. For example, if the option life is 10 years but you leave after five, your options will usually stop vesting immediately and will expire within several months of your termination date.