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Favorite Option Grant Mistake

   

Many mistakes can be made when granting employee stock options (ESOs), but while most will cause damage measured in dollars and cents, there is one major mistake that, in addition to having financial consequences – can hinder the company’s ability to manage its equity, and that, my friends, is dramatic.

The Nature of ESOs

We all know ESOs are the preferred incentive of fast-growing companies, elegantly linking remuneration to success without burdening cash-flow. From a legal aspect, it’s important to understand that ESOs are “compensation contracts” between an employer and an employee, and the rights and obligations of the parties are on the contractual level. It is this nature that makes most ESO grant mistakes relatively simple to resolve, at least from a legal standpoint.

When ESOs Go Wrong

Mature companies typically have mechanisms in place designated to monitor and control ESO grants, but when founders are bootstrapping they tend to do things absent-mindedly.

Some classic examples of ESO grant mistakes include: forgetting to set an exercise price; failing to define vesting or exercise periods; omitting an expiry date; committing to specific tax treatment; and – the BIG one you’ve been waiting for, promising a percentage of the company rather than a specific number of shares.

No Approximations, Please

Underwriters and investors must have a crystal-clear picture of your equity in order to minimize their exposure, and any difficulty in providing that picture will come at the expense of the company.

I may be stating the obvious, but equity must be revered, handled with proficiency and diligence.

When a company makes the move towards IPO or securing rounds of financing, it is crucial to be able to present clear and accurate data regarding the company’s equity. And by data I mean data – not approximations or speculations.

When ESOs Affect Equity

Back to the BIG ESO grant mistake: imagine an early stage company that has just hired a new CEO, promising 10% of the company as part of the remuneration package. Can you see the problem? If the company today has 100 shares it’s plain to see the CEO gets 10; but what happens when the company issues 100 more at its next round of financing – does the CEO get 10 or 20? And what if the Company has outstanding options, will the CEO’s percentage be calculated on a fully diluted basis? And does full dilution take into account only granted options or the reserved option pool?

These are but some of the questions that may arise and the longer the company waits between the “promise” and the “cleanup”, the more dramatic it gets.

Just to illustrate, we’ve even had optionees claim absolute anti-dilution protection! Clearly, it wasn’t the company’s intention to grant anti-dilution protection, and such mishap is always resolved before the next financing round. But under certain circumstances, for example when the 10% CEO has left the company, and even worse – having departed on bad terms and resisting cooperating, granting percentage ESOs can have a dramatic effect on the company.

And that’s why, if I had to chose my favorite ESO grant mistake – that would be the one.


Ran Dimant 300Ran Dimant is a Founding Partner of Katzenell Dimant and provides strategic and practical legal advice to corporations, institutions and business initiatives, addressing all aspects of their activity.

More posts by Ran here.

ran@kdlaw.co.il   +972.9.9500555   LinkedIn


DISCLAIMER: Blog posts are not designed to provide legal advice or create a lawyer-client relationship. You should not take action based on this content.

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