What happens to stock options when an employee leaves?

Employee equity programs, or employee stock option plans (ESOP) can be one of the best ways to incentivise and reward your staff.

• They motivate the key employees to think like a founder;
• They encourage the employees to stay with the company; and
• They can provide real value for the employee by letting them share in the success of the company.

However, sometimes a company might hesitate to offer ownership to employees.

Their worries might include:

• I don’t want ex-employees leaving with ownership, or
• I don’t want to have to fight about how much the stocks are worth if we want to buy them back.

There are a number of ways to protect an employer where an employee leaves. The process to follow when an employee leaves will depend on a number of factors. Most of the factors should be addressed in the equity agreement.

You can create your own standard employee equity agreement on Cake, which include the basic protections discussed. You don't have to do this from scratch, you can use our stock option offer letter template. You or your lawyer can also amend those Plan Rules, to make them work specifically for you. 

For a more general overview of ESOPs and how they work, check out comprehensive guide.

The Cake Glossary

Stock option terminology

First things first, depending on where you are in the world, these terms might be called differently. For the purpose of understanding this guide, let's define these terms:

ESOP

Employee Stock Option Plan is an employee equity sharing program that startups use to give their employees option to purchase shares in the company. In other jurisdictions, ESOP might be referred to Employee Stock Ownership Plan, EMI scheme, or ESOW. All of these are simply, employee stock options.

Plan Rules

The Plan Rules set out the rules and processes for option-holders and stockholders. You can think of the Plan Rules like additional Stockholders Agreement that only applies to employee stock option recipients. Plan Rules provide full transparency, helps avoid disputes, and gives the company peace of mind that it’s protected in various scenarios.

Vested vs. unvested options

Most Plan Rules will explain the process for options when an employee leaves, based on whether the options are ‘vested’ or ‘unvested’ options.

Generally, when an employee leaves, any options that have not ‘vested’ will lapse.

For example:

If an employee is granted 600 options; and

• 200 of those options vest after a 12-month cliff, and the remainder vest quarterly over 2 years; and then
• the employee leaves right after 12 months from the Start Date;
• then the remaining 400 options will lapse when they leave.

This means that those remaining 400 options can be transferred into the option pool, and re-allocated to a new or existing employee offer.

Vested options vs. exercised options

The Plan Rules will also contain similar terms relating to vested options and exercised options (or stocks).

Sometimes, the agreement will require an employee to ‘exercise’ their options before they leave the company. Or in other words, the employee will need to convert those options into stocks, before they leave. And if they don’t, then those options will generally lapse.

Buy-back rights

Some companies worry that an employee (who becomes a shareholder) could block future decisions if they leave with stocks. For this reason, the Plan Rules should set out clear and specific buy-back rights on those stocks.

The Cake standard Plan Rules allow the company to buy-back any stocks from an employee (or ex employee) shareholder, at any time after they leave, for a defined price. They also allow the company to order the transfer of those stocks to a third party.

By setting a clear process in the Rules, it avoids disputes relating to how the stocks are valued, and what the stockholder can do with them.

This also provides value to the employee, as it gives them an opportunity to achieve liquidity in their stocks when they leave.

Many companies will try to buy-back stocks from employees when they leave as much as possible, as it improves the diluted ownership of other investors, and also rewards ex-employees for their hard work. However, the company typically will not be obligated to buy the stocks back if it does not want to.

The stock price for the buy-back will depend on whether the employee was a good leaver or a bad leaver.

Good leaver vs. bad leaver

The buy-back price will be based on whether the leaver meets the definition of a good leaver or a bad leaver.

Where the employee is a bad leaver (for example, because he/she was terminated), the stocks will be set at a lower price (for example, 50% of fair market value).

A company is able to customise these definitions, to decide what they think is required to meet the good leaver definition.

The Rules will also set out how the fair market value is determined. Again, this will provide transparency and consistency across all options granted.

POA Provisions for uncooperative leavers

Finally, your agreement should include ‘Power of Attorney’ provisions, to further protect the company.

These provisions will allow the company to step in and execute documents on behalf of an employee, where it is in accordance with the equity

For example, it would allow the company to sign documents on behalf of an employee, in order to execute a buy-back under the Plan Rules.

The provisions also allows better efficiency for the company in general. For example, it can execute documents on behalf of the employees as part of a transaction (ie, for an IPO).

It's all in the rules!

The key to reducing chances of disputes is to ensure your Plan Rules set out the process, as much as possible.

The Plan Rules should protect the company, but also provide fairness and transparency to the employees.