What Happens to Your Stock Option When Company Owners Change?

When founders and key employees negotiate stock options, they often focus on vesting, exercise price, and expiration dates. What they frequently overlook is what happens if the company's ownership structure changes before the option is exercised.

A recent New York dispute involving a privately held company illustrates the problem. An executive received an option to acquire 20% of a company from its two shareholders. Before the option was exercised, one shareholder transferred his shares back to the company. Litigation followed over whether the option survived the transfer, whether the company was bound by the option, and whether the option holder had effectively exercised his rights. Years later, the parties were still litigating those questions. The lesson is simple: if an option can be defeated by a later stock transfer, it is not much of an option.

1. Make the Company a Party

One of the central disputes in the litigation was whether the option could be enforced against the company after one shareholder transferred his shares. The option was granted by the shareholders, not by the corporation itself. When ownership changed, the parties disagreed about whether the corporation had any obligation to honor the option.

A safer approach is to make the company a direct party to the agreement and expressly obligate it to honor the option if the original shares are transferred, redeemed, repurchased, or cancelled.

2. Create a Binding Successor Clause

Many option agreements assume that the current shareholders will remain owners until exercise. That assumption can be dangerous.

If the parties intend the option to survive future transfers, the agreement should expressly provide that any transferee takes the shares subject to the option and that successors and assigns are bound by the agreement.

3. Require Notice and Consent for Ownership Changes

The option agreement in the case contained extensive protective provisions designed to preserve the option holder's rights. Yet the litigation demonstrates that protective language may still leave room for dispute.

A stronger approach is to provide that no shareholder may transfer shares, and no company may redeem shares, without either:

• the option holder's written consent; or

• a written assumption agreement preserving the option.

4. Provide an Alternative Performance Mechanism

The agreement required the option holder to purchase shares from two specific shareholders simultaneously. After one shareholder left, the parties disputed whether performance had become impossible.

Avoid this problem by including a "substitute performance" provision, such as:

If the subject shares cease to be owned by the original shareholder, the company shall issue or transfer equivalent shares so that the option holder receives the same economic ownership percentage.

5. Record the Encumbrance

Many shareholder disputes arise because a later purchaser claims not to be bound by a prior agreement. The company should maintain records showing that the shares are subject to the option, and any new shareholder should acknowledge the restriction in writing.

6. Address Termination and Misconduct Explicitly

Another major dispute involved whether alleged misconduct by the option holder affected his right to exercise. The agreement apparently did not clearly address the consequences of termination, fraud, or disloyal conduct, leaving the parties to litigate doctrines such as unclean hands and the faithless servant doctrine.

A well-drafted agreement should state expressly whether the option survives:

• termination without cause;

• termination for cause;

• fraud;

• breaches of fiduciary duty; and

• post-termination competition.

Conclusion

Sophisticated parties often spend enormous effort negotiating valuation and economics but very little time thinking about what happens if the ownership structure changes before the option is exercised. As this litigation shows, failing to address those issues can transform a straightforward option into years of expensive litigation over who remains bound and whether the option still exists.

The best protection is simple: draft for the possibility that people leave, shares move, and relationships change. If the option is intended to survive those events, say so expressly.