How to negotiate an option agreement

Option agreements are routine contracts for scaleups – how can legal and HR teams make the negotiation process easier?

This deep dive looks at the use of option agreements at high-growth scaleups. We explore who these contracts affect, how parties might negotiate them and ways to make it easier. Use the navigation below to find out more, or explore our deep dives on other contracts, like NDAs and employment offer letters.

What’s an option agreement? | Who do they affect? | How to approach option agreement negotiations | How to negotiate option agreements more easily | Useful features | Learn more

What’s an option agreement?

An option agreement details the terms and conditions that give a party a right, though not an obligation, to buy an asset. The term ‘option agreement’ is widely used, but we most commonly see option agreements discussed in relation to the contracts startups and scaleups use to give share options to employees.

For the company issuing the options, it’s a great way to align the incentives of the business with those of its employees and to give them a stake in the company’s success. It distributes equity, but in a limited way. A company might want its employees to have a degree of ownership, but for all sorts of reasons it probably doesn’t want them to have voting rights to or be able to exercise their options short-term, for example. This is why options tend to come with vesting cliffs. Find out more in this venture capital jargon cheat sheet.

Companies might choose to issue options, rather than shares due to favourable tax treatment. Approaches vary between jurisdictions – in the US, the relevant instrument is the 409A valuation, introduced in 2007; in the UK, it’s the EMI scheme. 

Most employees have limited bargaining power when it comes to negotiating share options. The company is probably more reluctant to hand over equity than cash

Who do option agreements affect?

Option agreements affect various stakeholders across the business. Usually these include:

  • Legal counsel. The in-house legal team will own the template, with possible input from outside counsel when the employee option pool is established or changed.

  • People team. This team will usually send out option agreements to current or new employees. People teams will also work with legal to vary option arrangements at scale from time to time – check out this case study to see how.

  • CFO. The company’s chief financial officer (if it has one) will usually be responsible for management of the cap table, so she’ll want to monitor option agreements closely.

  • Board of directors. The company’s board members are interested in the precise details of ownership, particularly as they approach funding rounds.

  • Employees. New joiners will be issued options and existing employees might be granted additional option awards as they progress in the company.

The party opposite the employee or candidate is usually the corporate legal entity, with the CEO or CFO as the authorized signatory.

Most people switch off when they start reading about strike prices, liquidation preferences and vesting cliffs – no wonder they don’t feel able to negotiate terms

How to approach option agreement negotiations

Option agreements, in the context of startup share options, are certainly at the lower end of the negotiation spectrum – particularly compared to a more complex contract or even to the employment offer letter that might accompany it. There are a few reasons for this:

  • Power imbalance. Most employees have very little bargaining power when it comes to negotiating share options. A candidate hoping to join the company – particularly in a junior role – will have a hard time persuading the hiring manager to hand over more equity, given the company is probably more reluctant to hand over equity and cash. Plus, lots of people within the business might need to sign off on the options. It’s no surprise, then, that many candidates don’t bother to negotiate at all. 

  • Employees often consider salary first. Although share options might end up being worth many times more than a year’s salary, a monthly paycheck is much more tangible for most new starters. It’s also guaranteed, whereas a big payout from equity is by no means a certainty – or even probable in most cases. If new joiners are going to pick a battle, they often feel like salary is more worthwhile in the short term.

  • Lack of information. Parties to an option agreement often struggle to discern what’s actually being said – information design is a big issue and key terms can often be buried in impenetrable legal jargon ...

  • Lack of understanding … Plus, even if parties can find the relevant information, it can be difficult to understand precisely how share options work. Most people switch off when they start reading about strike prices, liquidation preferences and vesting cliffs – no wonder they don’t feel able to negotiate terms.

That said, option agreements are negotiated sometimes. And, generally speaking, failing to negotiate them at all is a missed opportunity for new employees.

Commonly negotiated points include:

  • Vesting timetable. A four-year timeline with a one-year cliff is common, but parties might look to negotiate this to make things happen faster.

  • Exit events – for example, what happens to my shares in the event of the sale of the company? Accelerated vesting is often a sticking point when senior hires negotiate their option agreements, to make sure they’re vested if an exit happens.

  • Good leaver/bad leaver provisions. Employees can be tripped up by punitive provisions that set out what makes a ‘bad’ leaver – for example, if firing results in the loss of share options, it can lead to bad incentives for the company.

  • Strike price. In certain circumstances it might be possible to negotiate the strike price of the options.

Which of these points the company is prepared to bend on will be a decision for key people and teams in the business – likely the CFO, the people team and, in some cases, the board.

How to negotiate option agreements more easily

Option agreements that are managed manually, across several different systems, are difficult to negotiate. A candidate might ask for a change to the PDF contract they’ve been sent, which the people team then reflects in tracked changes in the Word version of the document. The legal team reject the change, with an email to the people team to explain why. The people team might call the candidate to relay this and, after much back-and-forth and several more iterations, everyone reaches a compromise. A version of the agreement, which may or may not be the latest version, is sent across in PDF and signed. This clunky process takes time. Plus, all your negotiation data will be lost. 

If you use a contract collaboration platform to automate your option agreements, parties can negotiate key clauses in real time, in-browser. 

  • Your end-to-end agreement process will be faster.

  • All negotiation data and the full audit trail of changes to the document will be captured in one system of record.

  • You can use defined fallback positions, via conditional logic, to set parameters for permissible negotiation.

  • You can set up an approval workflow so that while people teams might self-serve on agreements, legal teams can still have final sign-off before negotiated terms are agreed.

What does end-to-end contract collaboration look like for a modern business? Find out in the ‘Modern contract handbook’.

Useful features

If you’re looking for software solutions to negotiating option agreements, here are some features that you’ll find handy:

  • Internal and external commenting and collaboration, so that internal colleagues and external counterparties can see, make and track changes to the contract.

  • Visual timeline and audit trail, so you can see when counterparties have viewed the contract.

  • Approval workflow, to make sure legal and leadership teams retain oversight of share option awards.

  • Full audit history, so you can easily compare different versions.

  • Integration with Slack and email, so that parties can be notified as negotiation happens.

  • Table views and custom dashboards, so contract owners can use custom dashboards to filter option agreements by different information – like the number of options, vesting date, signing status, and so on.

Negotiate better with Juro

Is managing routine contracts, like option agreements, at scale a pain point for your business? Is your SaaS company or marketplace growing so fast that the contract process is out of control, with friction pre-signature and a lack of visibility post-signature?

If so, get your free Juro account and see if you could benefit from a contract collaboration platform that enables businesses to agree and manage contracts all in one unified workspace.

 

Topics: Option agreement

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