How Employee Stock Options Work and Which Conditions Are Important — Column by REVERA

Source of illustration — Freepik

Nikolay Gorelik and Ekaterina Yakoltsevich

The trend of granting options to employees was set by the well-known (and often overused) example of the success of Google's employees. Instead of a high salary, the fortunate ones received options. After Google went public, they became millionaires. This was a win-win situation where the founders could reduce initial costs, and the employees could gain much more over time, albeit taking on certain risks.

If it was novel back then, today granting options to employees is best practice for IT companies. Based on our experience, even young game studios implement option programs for their employees. Often, the implementation of an option program is a requirement from investors that is fulfilled after closing a deal.

Before we begin, let's define some terms. Employee options, option program, option plan, and finally, ESOP are synonymous with one widely spread phenomenon in the IT industry. In simple terms, an option program is a set of rules to motivate employees by granting them rights to the company's shares.

Now, let's move to the mechanics of options and what needs to be done to implement an option program in your company. Step by step, options and their implementation in companies look as follows:

Stage 1. Implementing the Option Program

Many companies, especially at the startup stage, neglect this stage and do not legally formalize the option program but simply grant options to employees without contracts (basically just a verbal promise). This often ends in disputes and resentment when employees receive nothing or something entirely unexpected.

Therefore, the implementation of an option program and its legal formalization is an important stage that should precede the granting of options to employees. Typically, at this stage, necessary corporate approvals are obtained, sometimes a separate class of shares is allocated, and the rules of the option program are approved (who receives options, how many shares will be allocated for options (the so-called option pool), vesting period, what rights the employee will have, what rights the future shareholder will have, and what rights the participants will have regarding the disposal of shares/options).

Stage 2. Selecting Participants for the Option Programs

The second stage is selecting the employee who will receive the option, and entering into an option agreement with this employee. If the option program establishes general rules for granting options applicable to all employees, the option agreement outlines specific conditions for the particular employee. These conditions might include, for instance, KPIs, the number of shares, the vesting period (including the presence of a cliff).

Startup founders typically do not establish criteria for individuals who will be granted options since the workforce in startups is small, and identifying the necessary employees is not difficult. However, as the company grows, founders prefer to establish criteria for such employees, such as:

• work tenure;
• the specific position or role of the employee (e.g., department heads);
• the employee's achievements (e.g., meeting KPIs);
• approval of the candidate by the company's internal management body (e.g., approval by the board of directors).

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

Since the option implies that the employee will accumulate rights to shares during their tenure, option agreements include terms like the cliff and vesting. For clarity, let's explain these concepts.

Vesting is the period during which shares are accumulated for the employee. The employee can gradually buy the accrued shares as they vest or all at once at the end of the vesting period.

Besides vesting, companies use the concept of a cliff. A cliff is a period after the contract is signed during which no shares are accrued to the employee. Typically, this period is one year and is set to protect shareholders from dilution if the employee leaves shortly after being granted the option. The cliff is not a mandatory condition of an option program and can be set for all employees, selected employees, or not set at all.

Accrued shares can be gradually purchased by the employee as they vest 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 that the first part of the shares will be accrued to the employee only at the end of the cliff, and thereafter, over three years, the remaining shares will be gradually accrued.

Regarding the frequency of share accrual, companies also have variations: e.g., monthly accrual, quarterly, bi-annual, or annual.

The order of share accrual may vary:

1. Classic – shares are accrued in equal parts at regular intervals. For example, 10 shares in the first year, 10 in the second, 10 in the third, and so on.
2. Back-loaded – shares are accrued in increasing progression. For example, 10 shares in the first year, 20 in the second, 30 in the third, and so on.
3. KPI-based Vesting – shares are accrued only if KPIs are met. For example, in the first year, the employee must meet the revenue plan or complete game development, and shares will be accrued only if these KPIs are met.

Some companies use this type of vesting for all employees and all shares the employee can receive from the option. However, a fairer approach is to use KPI-based vesting for top managers and leading employees since they significantly influence achieving KPIs. It is also recommended to use this vesting type for only a portion of the shares, as there are objective reasons beyond the employee's control affecting KPI achievement.

4. Accelerated – shares are fully accrued upon the occurrence of a trigger event. Option plans often include a condition that upon the company's IPO or full sale, the employee receives all the shares specified in the agreement.

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

After the vesting period ends or other events occur (e.g., termination), the employee has the right to purchase the shares that have been allocated to them. The purchase of shares is essentially the employee exercising their stock option. Exercising an option involves paying for the shares and registering the employee as a shareholder of the company. It is from the moment of exercising the option that the employee becomes a shareholder and acquires all the privileges and restrictions imposed by the company's charter or shareholder agreement (if any).

Here we shall pause to discuss what rights related to the shares the employee will receive after exercising the option. It is commonplace to allocate a separate class of shares for options and to impose restrictions on such shares. These restrictions fall into two categories:

1) Voting – Employees may be allocated either voting or non-voting shares. The difference is that employees with non-voting shares do not have the right to vote at the shareholders' meeting, and accordingly, their shares are not counted in decision-making. It is important here to analyze whether local legislation permits the issuance of non-voting shares and proceed accordingly.

2) Restrictions on the transfer of shares. Given that the composition of the company's shareholders is a closed group of like-minded individuals, founders and investors are very reluctant to allow "outsiders" into this circle. To prevent such individuals from joining the shareholder group, the following tools are stipulated in stock option agreements, charters, or shareholder agreements:

• the right of first refusal by other shareholders, where the employee, before selling the shares to a third party, first offers them to the current shareholders for purchase;
• lock-up periods, i.e., a ban on the sale of shares for a certain period of time;
• approval of any sale by the other shareholders;
• other restrictions (e.g., a ban on selling shares for six months after an IPO).

In addition, situations often arise where an employee, having received shares, leaves the company, and ESOP sets conditions regarding the fate of these shares after their departure.

Some companies establish quite stringent conditions for the employee, according to which ceasing to work at the company means the employee loses the shares and must sell them back to the company or other shareholders. However, today this practice is extremely rare, as is the practice of allowing the employee to keep all the shares regardless of the reason for termination. The most common scenario involves tying the fate of the shares to various departure scenarios using the terms "good leaver" and "bad leaver." For example, an employee is considered a "bad leaver" if they are terminated for illegal activities, theft, violating the NDA, failing to meet KPIs, or breaching the contract. In this case, the employee must sell their shares to the company or other shareholders (often at nominal value). In other cases, they are considered a "good leaver" and retain the shares after termination.

Stage 5. The Long-Awaited Exit

The final and most enjoyable stage for the employee is the fifth. This stage occurs when the company experiences an exit. An exit includes a change in control of the company, an IPO, the full sale of all company shares, and other events. At this stage, the employee, having bought shares at a lower price, sells them at a higher price and earns a profit from the sale of the shares.

In summary, by going through these five stages, everyone will be happy: both the company, which had a motivated team striving for overall success throughout the option term and until the exit, and the employees who received a share of the overall success.