Canada: Employee Optionholders and Shareholders – Foresight is Key to Maintaining Flexibility for the Future

Companies often use stock option plans to attract, retain and motivate their employees and consultants, as well as to bring their interests into alignment with those of the shareholders. For early-stage companies, a policy of offering options has the additional advantage of conserving cash in the initial years. If such plans are not properly implemented, however, the options, or the shares issued on exercise of the options, may interfere with future financing or other transactions the company may later wish to undertake. When implementing a stock option plan, it is essential to draft the plan to ensure maximum flexibility for the company in its future transactions. Although the issues are too numerous to address completely, we have highlighted below some of the key areas to consider when drafting appropriate stock option plans and shareholders’ agreements.

An option plan that does not address an optionee’s rights in an acquisition situation can represent a significant roadblock, especially if the company receives an offer that requires that all of the issued and outstanding shares are to be acquired by the third-party acquiror. Will the options immediately vest and become fully exercisable and subject to be taken out as part of the take-over bid? While this can be of great benefit to the optionee, some buyers may want this feature, others will not. If the options do not vest, will it be possible for the optionee to convert the options to options for shares in the new company? For options that have already vested, will the options then be immediately exercisable or will the optionee receive options or shares in the new company? If not exercised, do they terminate before completion of the take-over bid? The best answer to these questions is to ensure that the board of directors retains maximum flexibility in determining how to treat existing options in the event of a sale transaction, and to give the board the authority to have all options terminate if not exercised prior to the completion of the sale. If these situations are not adequately dealt with in the option plan and option agreement, the company could be put in a situation where a few optionholders may be able to hold up the completion of a transaction.

Other issues can arise if a take-over bid is made but the acquisition is not completed. A common provision in an option plan is to make the exercising of options conditional upon the completion of the sale transaction. If the optionee chooses not to exercise his or her options prior to completion of the acquisition, then the options would expire, leaving the optionee with no further entitlements. Again, to avoid any ambiguity, it is imperative that these provisions are fully outlined in the option plan.

Upon the granting or exercising of options, or in a stock purchase plan situation, employee optionholders and shareholders should be required to enter into a shareholders’ agreement. If a unanimous shareholders’ agreement does not exist, it is important that the employee shares are subject, at a minimum, to restrictions on transfer and a "drag-along" clause. Restrictions on transfer are necessary to ensure the company does not end up with shareholders it did not expect. A drag-along clause provides that, upon receipt of a bona fide take-over bid from a third party, a majority of the shareholders (the exact percentage can be specified) can agree to the take-over on behalf of all shareholders. The majority shareholders then have the right to require the remaining shareholders to sell all of their shares to the third-party acquiror pursuant to the terms of the take-over bid. This, coupled with a power of attorney that may be exercised if a shareholder fails to comply with the drag-along clause, is designed to allow the majority shareholders to complete the take-over bid without needing the consent of every minority shareholder.

In the event the company has a unanimous shareholders’ agreement, consideration should be given to whether 100% consent should be required for all amendments to such agreement. Companies have found themselves facing difficult restructurings (as well as the incumbent legal costs) in cases where a very small number of shares are held by one or more dissident shareholders who refuse to cooperate with the company’s plans, which require amendments to the unanimous shareholders’ agreement to proceed. More often than not, such shareholders are former employees terminated by the company.

Where there is no unanimous shareholders’ agreement, it may be prudent to consider entering into separate minority shareholder agreements between the company and each minority shareholder. The distinct advantage to separate agreements is that each one can have slightly different terms as may be necessary (now or in the future) to address each holder’s unique circumstances. This avoids the necessity of unanimous (or close to unanimous) consent to amend a unanimous shareholders’ agreement. Some of the possible disadvantages to creating separate agreements include that a unanimous shareholders’ agreement automatically binds purchasers as long as the shares are legended to provide notice of the agreement (whereas an individual agreement would not automatically bind) and that the corporate statutes provide additional mechanisms to enforce the provisions of a unanimous shareholders’ agreement.

It is also important for option plans and shareholders’ agreements to address what will happen when the employment of an employee holding shares or options is terminated. With an option plan, the company will typically want to ensure that any unvested options are forfeited upon termination, but the option plan must be very clear in this regard. A pattern has emerged in court decisions over the last several years whereby, in the absence of very clear language in the plan, courts will likely interpret the plan language so as to permit an employee to continue to participate in the plan during the applicable reasonable notice period required to terminate their employment. Accordingly, it is imperative that the plan clearly limit rights of the employee upon a termination of employment if that is, as is usually the case, desired.

Shareholders’ agreements must also address termination issues. A company may be reluctant for terminated employees to receive financial and other information about the company, particularly if the employee begins to work for a competitor. As a result, shareholders’ agreements often provide an option for the company (and/or others) to repurchase the shares of an "inactive shareholder" (inactive by reason of bankruptcy, conviction of an offence, death, disability or termination of employment, for example), with prices sometimes differing depending on the "fault" or "no-fault" nature of the triggering event. Employees will often try to negotiate a mandatory purchase by the company; however, many companies resist the requirement to use company monies to fund the repurchase of a departing employee’s shares. Mandatory purchases may be more acceptable in the event of death, both since an employee’s estate will face a deemed disposition, and the accompanying income taxes on capital gains, and because a company can, if it wishes, generally purchase life insurance (assuming that the employee is eligible) relatively inexpensively to fund the purchase obligation.

In addition, companies may wish to draft their option plan to allow for cancellation of any vested or non-vested options if the employee does not comply with the terms of certain agreements made with the company, including confidentiality, non-competition or non-solicitation agreements. This is to address the situation of key employees leaving the company either to start up or join a competing company or otherwise improperly soliciting company clients.

Managing the termination of employees and their rights under option plans and shareholders’ agreements can be extremely difficult and time-consuming and should be dealt with at the time of drafting the option plan and shareholders’ agreement, well before relationships may have changed or deteriorated.

It is essential that the issues addressed above, among others, be carefully considered and addressed in a stock option plan or a shareholders’ agreement in order to avoid problems in the future that could prove to be significant hurdles to the company in its future financing or other transactions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.