Equity Isn’t Equal: How Stock Options Work Differently After a Delaware Flip
As discussed in our previous article, “Understanding the Delaware Flip: What UK Founders Should Know,” in a “Delaware flip” a UK (or other non-U.S.) company forms a new U.S. parent company—typically in Delaware (“TopCo”)—and the UK company’s shareholders exchange their shares for equivalent TopCo shares. This raises the question—what exactly happens to existing UK options?
An option over UK company shares does not automatically become an option over TopCo shares when the shareholders exchange their shares. The flip documents must specify how each outstanding award will be treated. Depending on the plan terms, tax objectives and transaction mechanics, options may be assumed or exchanged by TopCo, exercised before the flip, cashed out or canceled and regranted.
Most commonly, TopCo either assumes the options or exchanges them for options under a newly adopted TopCo plan. The practical differences are:
- Assumption. TopCo steps into the UK company’s existing plan and option agreements, so the options continue on their original terms but cover TopCo shares. Optionholders typically receive a short notice confirming the change.
- Exchange. The UK options are canceled and replaced with new options governed by TopCo’s new equity plan and form of award agreement, which each optionholder typically must sign.
In either case, the number of shares and exercise price are usually adjusted to preserve the award’s economic value (the “spread”), and the original vesting schedule, exercise period and option term generally carry over.
EMI and Other Tax-Advantaged Options Require Particular Care
If the UK company has granted tax-advantaged options—such as EMI or CSOP options to UK taxpayers or incentive stock options (ISOs) to U.S. taxpayers—the tax benefits can often be preserved in the replacement TopCo options, provided the statutory requirements of each regime, which differ, are met.
Cross-Border Awards Also Need a Separate Review
For any optionholder who is or may become subject to U.S. tax—for example, a UK employee who relocates to the U.S. after the flip—the adjustment should also be tested for compliance with the U.S. tax rules governing the substitution or assumption of options in a corporate transaction, and to verify that the original option did not include a discounted exercise price, as is sometimes the case with EMI options or so-called “nil-cost” options.
Once the optionholder becomes subject to U.S. tax, a discounted or nil-cost option is generally treated as deferred compensation which fails to comply with Section 409A, even though it was granted while the holder was not a U.S. taxpayer.
Where a transfer to the U.S. is anticipated, the company should consider addressing these awards before the relocation, such as by amending them to comply with Section 409A, increasing the exercise price to fair market value (FMV) (with any make-whole for the lost spread) or replacing them with restricted stock units (RSUs), taking into account the UK tax consequences of any change, including any impact on EMI status.
Who Approves an Option Grant and When It Is Made
The approval process is one of the most significant operational changes after a flip. The rules depend on TopCo’s state of incorporation; the discussion below assumes TopCo is a Delaware corporation.
After a Delaware flip, options are granted by board resolution under the Delaware General Corporation Law and the equity plan. The board may approve awards itself or act through a properly authorized committee or officer, the latter of whom must stay within the limits of the board resolution and may not grant an option to himself or herself.
For U.S. tax purposes, the grant date is generally not the date the employee clicks “accept” or signs the option agreement; it is the date the corporation completes the corporate action necessary to create the legally binding right, provided the recipient, class and maximum number of shares, minimum exercise price, and other essential terms are fixed or determinable. In a routine grant, that is often the date of board or committee approval. The grant date can be later if material terms remain open, approval is conditional, communication to the recipient is unreasonably delayed, or a delegate has yet to select the recipients or award amounts.
The distinction matters because grant-date FMV sets the minimum exercise price for an ISO and for an NSO intended to be exempt from Section 409A. Companies should not backdate awards to an offer letter date, employment start date or earlier valuation date. The vesting commencement date, however, can precede the grant date.
The board approval should identify the recipients, number and type of awards, exercise price, vesting schedule and term, or incorporate a schedule containing those terms. Award agreements should be delivered promptly, and the cap table should match the corporate record.
Securities Law and Administration Do Not Stop at the Plan
Granting an option is an offer and sale of a security under U.S. federal and state securities laws. Private U.S. companies commonly rely on Rule 701 under the U.S. Securities Act of 1933 to exempt compensatory grants to employees, directors and certain natural-person consultants and advisors from registration. Rule 701 has eligibility, volume, disclosure and delivery requirements, and a state securities law exemption is also needed. If Rule 701 sales exceed $10 million in any consecutive 12-month period, additional financial and risk disclosures generally must be delivered within the required timeframe.
The company must also continue to satisfy local securities, employment and tax requirements for participants in the UK and in other countries.
(For a checklist of steps to take before and after the flip, click here.)
This article is the first article in a series of three articles that unpacks how stock options are treated in a Delaware flip, what a UK startup founder needs to know about granting stock options in the new U.S. TopCo, and how the U.S. approach differs from the UK framework.