May 13. 2022

What are options?

Here we go into detail on the most common equity compensation: Options.

A risk-free incentive - which gives the participant the opportunity to take part in future growth.

Options are a right to be able to buy shares in a company in the future at a price agreed today.

Generally


Options usually have a vesting period, as well as an expiration date. The employee must exercise the option in the period between the vesting date and the expiration date. The option also has an exercise price (also often called a redemption price and strike), which is a pre-agreed price for which the shares can be purchased. It is usually a condition that the employee works in the company from the option is granted until a vesting date (vesting date) in order to have earned the right to the option. This means that the participant as a rule does not lose the option if he / she quits after this. The employee can exercise this right from the time of vesting until the options expire.


How to set the redemption price?

 

Options are usually granted with the intention that there will be a gain for the participant given that the share price goes up. Therefore, it is most common to grant options, where the exercise price corresponds to the market price at the time of grant (preferably a volume-weighted average a few days in advance if the company is listed and has frequent trades). However, there are no restrictions on what the redemption price should be. If you think that the share price should rise significantly and you want the participant to have something to reach for, you can "plus a little" - here it is common to define a certain percentage above the market price. Here we recommend setting the redemption price from time 0 and not having a redemption price that rises slightly each year after allotment. Is it e.g., it is desirable that it should increase by 5% a year until accrual after 3 years, rather set a redemption price of 15,

 

How long is the vesting period?

 

Here the most important thing is to think about the situation of the company and what kind of people will receive the options. If the company has a “make or break milestone” in three years, set the vesting period for the options to three years from today. This naturally means that the binding effect of the options is utilized to the maximum. That said, one must also consider whether the employees consider three years as too long for "something happens" - and whether this is something you want to take into account.

Precisely this type of assessment means that you often end up with split earnings. We believe it is important to remember that these options are often intended as a long-term incentive program, and therefore that you keep the largest carrot a little out of time. Given that it suits your company and your plans - we prefer to divide the earnings over three years, but maybe let participants earn something after 1, 2 and 3 years. For example, 25% after one year, 25% after two years and 50% after three years. If the company value has increased during the period, the participant will "lose" the largest share if he or she quits before three years have elapsed, but it has been possible to redeem something before that time. If one thinks that the allocations should be annual, this model will also create activity in the plan.

 

Exercise of options?

 

When the share is to be exercised / redeemed, it is most common for the employee to pay the redemption price to the company and receive one share per exercised option - this is typically by the company issuing new shares (the company can also choose to use shares from its own portfolio or buy shares specifically for this purpose). In some cases, participants can also receive a settlement from the company on the difference between the exercise price and the market price at the time of exercise (synthetic settlement). Such a settlement requires that the market price can be determined relatively objectively, and therefore works best in companies that have a liquid market for trading (typically companies listed on a form of stock exchange). Otherwise, it should be agreed in advance how the value of the share will be confirmed when the time comes.

 

Set expiration date

 

Expiration date is something you use for several reasons.

This may be to ensure that the company is not left with a confusing and inappropriately large proportion of options. In cases where, for example, the share price is lower than the exercise price, the options will not be exercised.

  • It may also be the case that participants who hold vested options and have left the company have to sit with these options "forever" (they often agree to avoid such cases in the option agreement).

  • In cases where the company includes the costs in the accounts (mainly where the company keeps accounts in accordance with IFRS), a late expiration date may lead to a higher accounting cost.

  • We recommend that there be some time between the vesting date and the expiration date to ensure some flexibility. There may be company-specific events which mean that the options cannot be exercised in periods, there may also be periods where it is more difficult to make redemptions in terms of liquidity and the fact that the share price may be down in a “valley” at the time of vesting.


If you use the vesting structure proposed above, you can, for example, let the options expire five years after allocation, regardless of when they are vested. This will mean that the last "partial award" is earned two years before it expires.

 

History

 

Options have been in use for at least 50 years. It began as an opportunity for companies to offer selected executives and board members share options "at-the-money" - without it having to be entered as income on the tax return since the options themselves had no value. The practice was relatively uncommon. But in the nineties, cash bonuses were set in many countries, including the United States. Options then became a popular way to offer key employees' extra compensation, driven by strong growth on the stock exchanges - and especially in technology stocks. Soon it was not only the management that received options, but employees at all levels. Options had become a tool used to create competitive advantages through recruitment and the ability to retain key employees - especially young talent who did not mind taking a lottery ticket for future big wins rather than an extra bonus on the paycheck. This also provided an added benefit for start-up companies with shallower trouser pockets, which could thus massage their liquidity and save cash by issuing more and more options - without the transactions having to be expensed.

 

Tax on options

 

For tax purposes in Norway for instance, as a rule, the entire difference between the exercise price and the market value (i.e., the gain) is to be regarded as salary, and is to be taxed as salary. Processes are underway that are examining the possibility of changing the tax rules for share options for Norwegian start-up companies, and some tax benefits were introduced in 2018. It is worth mentioning that the changes are very few - and have little significance here due to scope. See example below for an illustration of tax on options.

The employer must thus pay employer's contribution on this gain. The company will also receive a tax deduction in the same way as with a salary, provided that the shares have been bought into the market or shares from its own holding have been used. From the moment the share is purchased (the ownership of the share has been transferred), the value development is regarded as capital income at current rates.

In 2018, approx. three quarters of the companies listed on the Oslo Stock Exchange's Main Index share pay as part of the financial compensation. Options are the most popular instrument with about 50 percent against other instruments. More than 90 percent of the options apply to shares, rather than cash or synthetic.

 

 

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 redemption 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.

 

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