What are employee stock option grants and what advantages do they offer to companies?
The grant of stock options is one of the main employee remuneration tools in high-tech companies. This is especially true of startups in which options compensate for relatively low wages, but also for established companies. Options constitute not only a potential financial benefit for employees and service providers, but also a strategic mechanism designed to strengthen commitment and create a correlation between employees’ achievements and the company’s long-term success.
Stock options offer a company’s employees and service providers a future right to purchase company shares at a predefined preferential price. In most cases, option recipients may only exercise options after a gradual vesting period and subject to predefined conditions, such as progress in closing a transaction or the achievement of targets.
It is important for companies to understand that they must take statutory and tax requirements into account already during the initial stages of designing an employee stock option plan (ESOP).
Formulating and adopting an ESOP
Companies that want to grant stock options to their employees must adopt an ESOP that stipulates the grant principles, vesting mechanism, exercise terms, procedures in the event of employee severance, etc. An ESOP must be approved by the company’s board of directors and, sometimes, also by the general meeting (depending upon the company’s articles of association). The company must also set aside a pool of shares from its share capital, from which it can grant options in the future.
Once the ESOP is duly approved, and in order to receive the tax benefits specified below, the company must engage with a tax trustee approved by the Israel Tax Authority (ITA). By law, options granted pursuant to section 102 of the Income Tax Ordinance (as further explained below) must be transferred to a trustee. Furthermore, the company must submit the approved ESOP to the tax assessor at least 30 days prior to any actual grant.
Stock option recipients and the statutory differences between them
When granting stock options, it is important to differentiate between categories of option recipients. Israeli law prescribes one tax track for employees, officers, and directors who are not controlling shareholders (controlling shareholders hold more than 10% of the company or are entitled to appoint a director of the company even if they hold less than 10%), and a different tax track for consultants, service providers, and external suppliers.
Grant of stock option pursuant to section 102 of the Income Tax Ordinance
Section 102 of the Income Tax Ordinance prescribes the main tax framework for granting stock options to Israeli resident employees, officers, and directors who are not controlling shareholders. Section 102 offers significant tax advantages upon the fulfillment of the following statutory preconditions: the company grants the options through a trustee approved by the ITA, the trustee holds the options for a minimum of 24 months, the trustee holds the exercised shares until they are sold, and the company strictly complies with the reporting and filing requirements. In this tax track, the tax liability is deferred until the shares are sold, and the tax is calculated at the capital gains tax rate of 25% on the profit generated at the time of the sale.
Grant of stock option pursuant to section 3(i) of the Income Tax Ordinance
Section 102 does not apply to stock option grants to external consultants, freelancers, contractors, or service providers not deemed employees pursuant to the law. For them, companies must act in conformity with section 3(i) of the Ordinance, which obligates the offeree to pay tax already on the option exercise date at the usual marginal tax rate (up to 50%), without any deferral of tax or benefit.
Therefore, when formulating an ESOP and deciding on stock option grants, companies must ensure they correctly categorize the status of the benefit recipients. The correct categorization of option recipients is not merely a technical matter, since it also determines the applicable tax track and the economic impact of the benefit as a whole.
Grant of stock option and exercise process
In addition to obtaining the board of directors’ approval of the ESOP, companies must also obtain their boards’ approval for each individual stock option grant, as well as option recipients’ signatures on personal option agreements stipulating all details of the benefit. Companies must ensure they properly and accurately carry out the option grant and management process (especially when granting options pursuant to section 102 of the Ordinance):
- The company must forward the board of directors’ resolution approving the option grant to the trustee within 45 days of the date of the resolution.
- The company must deliver the signed option agreement to the trustee within 90 days of the date of the board of directors’ resolution.
- The company must immediately inform the trustee of an option exercise by an option holder.
- The company must immediately inform the trustee of the severance of an option holder’s employment.
- The company must immediately inform the trustee if an granted option is exercised within 90 days.
These time frames are material, and failure to comply with them could prevent option holders from benefiting from the tax benefit pursuant to section 102 of the Ordinance.
Is an undertaking to grant options actually binding upon the company?
Companies sometimes undertake to grant options to employees in employment agreements or other agreements with them. It is important to understand that such an undertaking is not sufficient in and of itself.
For the undertaking to be enforceable, the company must already have formally adopted an ESOP, appointed a trustee, and be legally capable of actually granting options. A general undertaking to grant options that is not accompanied by practical implementation measures could create legal ambiguity and even exposure (as in the Kovach ruling; click here for a full update in this regard).
Therefore, we recommend that companies ensure full statutory compliance and documentation of each stock option grant.
Summary of the guiding principles when adopting an ESOP
Although the grant of stock options to employees and service providers is an effective and strategically valuable way to remunerate employees and strengthen their commitment to the company, they require precise planning, strict adherence to procedures, and compliance with statutory requirements. Before companies actually grant stock options, they must consider the economic and regulatory implications, design an orderly ESOP that conveys a clear policy and stipulates customized conditions, and receive all requisite approvals. It is essential that companies complete this process correctly and completely in order to ensure they and their employees qualify for the economic and tax benefits.
Expert legal counsel is essential from the outset in order to avoid costly mistakes; ensure full compliance with the statutory provisions; and create a stable, efficient, and effective remuneration mechanism that fully leverages the advantages offered by this important remuneration tool, thus effectively advancing the company’s objectives over time.
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Adv. Ken Shaked, a partner in our firm’s Corporate Department, specializes in providing ongoing legal assistance to high-tech companies, entrepreneurs, and startups.
Adv. Daniel Adler is an associate in our firm’s Corporate Department.
Barnea Jaffa Lande’s Corporate Department provides end-to-end legal counsel to high-techs and startups companies during all stages of their local and international operations, including advice on private and public financing and fundraising, tender offers, corporate restructuring, commercial agreements, merger and acquisition transactions, collaborations, corporate takeovers and control struggles, corporate splits, asset acquisitions, and regulation.