Options grant employees the right to purchase company shares at a predetermined price in the future. They serve as a risk-free incentive, providing participants with the chance to partake in the company's future growth.

Options typically come with a vesting period and an expiration date. During the period between the vesting date and the expiration date, the employee is required to exercise the option. The option also has an exercise price, also known as a strike price, which is the predetermined amount at which the shares can be bought. Generally, it is a requirement for the employee to remain employed by the company from the grant of the option until the vesting date in order to earn the rights to the option. Consequently, if the participant chooses to leave the company after the vesting date, they typically do not forfeit the option. The employee has the ability to exercise this right starting from the vesting date until the options reach their expiration date.

How to set the strike price?

Options are typically granted with the expectation that participants will benefit if the share price increases. Therefore, it is common practice to grant options with an exercise price matching the market price at the time of the grant, preferably using a volume-weighted average a few days prior, especially for listed companies with frequent trades. However, there are no restrictions on the selection of the strike price. If you anticipate a significant rise in the share price and wish to provide participants with an ambitious target, you can set the strike price slightly higher. It is often customary to define a certain percentage above the market price as a reference. In such cases, we recommend establishing the strike price at the outset and avoiding annual increments after the allotment.

How long is the vesting period?

When considering options, it is crucial to assess the company's circumstances and the individuals who will be receiving them. If the company is facing a critical "make or break" milestone in three years, it is advisable to align the vesting period of the options with that same timeframe. This ensures that the options have the highest impact and significance during this crucial period. That said, one must also consider whether employees perceive three years as excessively long before "something happens," and whether this aspect should be considered in the decision-making process.

This type of assessment often lead you to end up with split earnings. Remember, options are meant as long-term incentives, so it's best to delay the most substantial reward. Depending on what aligns with your company and its plans, we recommend considering a split payout over three years, with participants earning a portion after 1, 2, and 3 years. For example, 25% after one year, 25% after two years, and 50% after three years. By structuring the payout this way, it allows participants to receive a portion of the rewards earlier, while still preserving the most substantial incentive for the long term. If the company's value increases during this period, participants who leave before the full three years will "lose" the larger share of the rewards, but they will have the opportunity to redeem a portion before that time. If you prefer an annual allocation approach, this model will also generate ongoing engagement and activity within the program.

Exercise of options?

When exercising or redeeming the options, it is most common for the employee to pay the strike price to the company and receive one share per option exercised. This is typically done through the company issuing new shares, although the company may also choose to use shares from its own portfolio or acquire shares specifically for this purpose. In some cases, participants may also receive a settlement from the company based on the difference between the exercise price and the market price at the time of exercise (known as synthetic settlement). However, this type of settlement requires that the market price can be determined relatively objectively, and therefore works best in companies that have a liquid market for trading, such as those listed on a stock exchange. Otherwise, it is important to agree in advance on how the share value will be determined when the time for exercise arrives.

Set expiration date

Setting an expiration date for options serves multiple purposes.

It helps prevent the company from being burdened with an excessive number of options that may lead to confusion. In cases where the share price is lower than the exercise price, the options are unlikely to be exercised.

• It avoids situations where participants who have left the company continue to hold vested options indefinitely. Typically, option agreements include provisions to prevent such scenarios.
  
  
• If the company includes option costs in its financial statements, particularly when following International Financial Reporting Standards (IFRS), a later expiration date can result in higher accounting expenses.

• We recommend incorporating a time gap between the vesting date and the expiration date to allow for flexibility. Certain company-specific events may make it impractical to exercise options during certain periods. Additionally, liquidity concerns and fluctuations in share prices can make it challenging to strike a deal at the time of vesting, especially when the share price is low.

By adopting the proposed vesting structure, you can consider setting the options to expire five years after allocation, regardless of the vesting period. This approach ensures that the final partial award is earned two years before the options expire.

History

 Options have been utilized for over five decades, initially serving as an opportunity for companies to provide selected executives and board members with share options "at-the-money." This approach allowed the options to be exempt from being reported as income on tax returns, as they held no inherent value. Initially, this practice was relatively uncommon.

However, in the 1990s, many countries, including the United States, began adopting cash bonuses as a common form of compensation. During this time, options gained popularity as an additional means of rewarding key employees, fueled by the substantial growth in stock markets, particularly in the technology sector. Consequently, options expanded beyond management and became accessible to employees across various levels.

Options emerged as a strategic tool to create competitive advantages in terms of recruitment and retention, particularly for young talent willing to embrace the potential for significant future gains rather than immediate bonus payments. Start-up companies, in particular, found options advantageous as they could conserve cash by issuing more options without incurring immediate expenses.

Overall, options evolved into a widespread practice, enabling companies to incentivize and retain valuable employees while managing liquidity and financial resources effectively.

Tax on options

In Norway, the general tax rule dictates that the entire gain, which is the difference between the exercise price and the market value, is considered salary and subject to taxation as such. However, ongoing discussions are exploring potential changes to the tax regulations concerning share options for Norwegian start-up companies. In 2018, certain tax benefits were introduced, although their impact is limited in scope. The company is eligible for a tax deduction, similar to that of regular salary expenses, if the shares have been acquired from the market or from the company's own holdings. Once the shares are purchased and the ownership is transferred, any subsequent value development is treated as capital income, subject to prevailing tax rates.

In 2018, approximately three-quarters of the companies listed on the Oslo Stock Exchange's Main Index included share payments as part of their financial compensation packages. Among these companies, options were the most popular instrument, accounting for about 50 percent of the total, surpassing other forms of compensation. Furthermore, more than 90 percent of the options granted were related to shares, as opposed to cash or synthetic equivalents.

Summary

1. Advantages of options:

2.  

• No risk for participant.
• No taxation for participants before the option is used.
• No employer's contribution before any gain on the options.
• No actual dilution for shareholders unless the company value increases during the period (provided that the strike price corresponds to the market price at the time of allotment)
• Binding effect on key employees and perceived value in times when the share price rises and remains stable.
• Higher “leverage” than for ordinary shares as the participant will have more options (due to lower cost and dilution per instrument).
• Options are nothing more than an agreement before they become an actual share. This makes it administratively efficient to administer. You do not need a structure for share accounts etc. before the options become actual shares (note, however, accounting management under IFRS).

1. Disadvantages of options:

• Gains on the option are taxed on wages, in addition the company is obliged to pay employer's tax on this.
• No direct "skin in the game" can be considered negative for the company.
• Low binding effect and perceived value if the share price falls over time.