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By: Adv. Amir Raz, Adv. Sagit Shuval-Moked and Adv. Shay Fahima
One of the most common compensation tools in startups is stock options, which are simply called “options”. In many cases, the options are granted under capital tax routes that benefit the employees (“Capital Gain Route”, or “Section 102” in Israel, and “ISO” in the USA). The granting of the options is usually carried out by the Board of Directors, which determines the terms of them, and among other things, their vesting period (vesting) and their exercise price (exercise price). Under the tax laws, options are subject to minimum holding periods in order to benefit from the tax benefits (in Israel – two years of holding the option or the share resulting from it from the date of grant of the option through a trustee, and in the USA – two years of holding the option or the share resulting from it from the date the option was granted and in addition the year of holding the share from the day the option for the share is exercised).
According to the provisions of the capital gains route, regarding Israeli employees in private startups, there is generally no limit on the exercise price determined in the granting of options, however in the US the exercise price must be at least the fair market value of the stock at the time the option is granted according to section 409A of the American tax code , otherwise an immediate tax will apply at a relatively high rate. In order to comply with the rules, private companies that grant options to employees and service providers in the US use external valuation services. As a general rule, the valuation is done every 12 months, unless in the interim period a substantial event occurs that may affect the value of the company’s shares, such as an investment in the company, a huge contract, substantial success in an experiment, a purchase offer as well as exogenous factors such as the state of the markets, etc., in which case the company is required to refresh the valuation before the end of the period.
In recent times, we have seen declines in the fair value of employee options in many startup companies. Most of these decreases are due to market conditions, a decrease in the multiples of similar public companies, and some of them due to a decrease in activity. This decrease means that options granted during the high tide period of the last two or three years at an exercise price equal to the fair market value at that time are “out of the money” and may miss their purpose as a tool to motivate and retain employees.
Ways of dealing with “out-of-the-money” options
In such a situation, the board of directors of a company that wants to maintain the attractiveness of the options has several options:
do nothing – If the board of directors thinks that this is a temporary decrease in value, and it expects that the value will return and increase in the short term, without the lack of action leading to employee frustration, it can decide to leave the situation as it is.
to grant additional options at the new value (refresh grants) – on the assumption that it is a decrease in value that is not material, the granting of additional options at the new price may be sufficient. In order not to change the conditions of granted options, it is possible to grant new options to employees who hold options that are “out of the money” at an exercise price according to the current market value. By its very nature, the act of granting additional options is limited in terms of the amount granted and accordingly does not fully compensate for the options granted in the past and in addition it dilutes the shareholders, so it is not suitable for a situation of a drastic decrease in value.
repricing – Reducing the exercise price of previously granted options to the new value. The advantages of the move are that it is a move that does not dilute the shareholders further than the existing one, and compensates the employees for the full decrease in value. However, one must prepare for such a move in advance, and examine its consequences according to tax laws and securities laws, as well as its accounting consequences. For example, in terms of the tax consequences – the reduction of the exercise price is a tax event for employees in Israel (if a special approval called ‘rolling’ is not obtained from the tax authority) and in any case the holding period in trust will be renumbered for the Israelis, and for the Americans in most cases the pricing will be a new grant date for the ISO for all that is implied by this (including a re-examination of ISO’s financial limitations); In terms of the application of the securities laws to such an offer: in certain circumstances the move may require compliance with the conditions for holding a tender offer regarding the American employees and it also requires an examination of the company’s compliance with the provisions of the exemption from publishing a prospectus for a private company according to the Israeli Securities Law. From an accounting point of view, the move requires recording an additional expense in the company’s books equal to the value of the additional benefit. Also, the company’s income from paying the exercise price may be lower. In conclusion, the execution of the process is complex and requires an examination and integration of various disciplines (starting from HR considerations and compensation for employees, through tax considerations and securities laws in Israel and the USA to accounting considerations).
exchange of options – In contrast to reducing the exercise price, this alternative means canceling the options held by the employee and carrying a high exercise price, and replacing them with new options with a lower exercise price equal to market value, or restricted share units (RSUs, which do not carry an exercise price). Such an exchange may be done in a 1:1 ratio or in another ratio on the basis of preserving the same economic value of the canceled options as it was at the time they were granted also in the new capital reward package that will be granted. Such a move is similar in terms of its complexity to the move of repricing and even consists of it, especially with regard to the preparation of the cancellation and allocation documents and compliance with the provisions of the various securities laws.
Adopting a carve out plan – This is about granting a new reward, capital reward or in cash, which will allow employees priority over the company’s investors in receiving purchase funds in the deal. Such plans come to deal with a situation in which, with many investment rounds and the company’s value, the employees’ options, which are for ordinary shares, will not get them any reward in a future purchase deal with a high probability. The adoption of capital plans of this type is not simple at all, and such plans also require an update of the company’s articles of association and obtaining a special approval from the tax authority.
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Changing vesting conditions and adding eligibility conditions due to the repricing – Companies that have re-priced or exchanged options are considering whether to continue the existing vesting without change, or to change the vesting by extending it or by adding a cliff. Similarly, there are companies that state that the repricing will take effect after a certain “qualification period” and not immediately, so that an employee who leaves the company within a short period of time will not be able to enjoy the benefit.
Who is eligible for repricing? Companies must consider who the repricing will apply to – all employees or certain employees, for example employees with a certain seniority.
The decision was made. What now? After the company has considered all the considerations and made the decisions, it is very important to communicate the move transparently to the employees either in writing, in personal conversations or in a conversation with all the company’s employees (town hall meeting).
Repricing (by way of reducing the exercise price or replacing the options) is a move that carries with it a very significant benefit for the employees, but it is not simple and must be done after thinking and preparing in advance, in order to exhaust its advantages in order to retain and motivate the company’s employees.
Adv. Amir Raz, is a partner in the high-tech department of the Goldfarb firm, Gross Seligman; Adv. Sagit Shuval-Moked is a partner in the tax department of the Goldfarb firm, Gross Seligman; Attorney Shai Fahima is a partner in the tax department of the Goldfarb firm, Gross Seligman.