On Jan. 21, 2018, Tesla, the electric car manufacturer (also in the business of sustainable energy generation and storage), granted its chairman and chief executive officer, Elon Musk, an option, subject to shareholders' approval, to acquire 20,264,042 shares of Tesla (representing 12 percent of the then outstanding shares). Tesla's shares are traded on NASDAQ. As of the grant date of the option, the market cap of Tesla was approximately $59 billion.

The grant-date value of the option, according to the proxy statement for the special meeting noted below, was approximately $2.6 billion, based on a so-called “Monte Carlo” option pricing model, a mathematical model used to provide an estimate for the fair value of an option at the time of grant. The option exercise price is $350.02 per share, the January 19 closing price for a share of Tesla stock. To the author's knowledge, this is the largest stock option ever granted by a public company to an executive. According to the same proxy statement, Mr. Musk “will receive no salary, no cash bonuses and no time-based equity awards that vest solely through the passage of time (that is, simply by continuing to show up for work).”

The grant of the $2.6 billion option was approved by shareholders at a special meeting held March 21, 2018. Approximately 73 percent of votes cast, excluding votes of shares owned, directly or indirectly, by Mr. Musk (owning beneficially approximately 22 percent of Tesla's shares) and his brother Kimbal Musk (owning less than 1 percent), voted in favor of the option grant.

Musk Option Features

The following discussion addresses a number of unique features of the option grant to Mr. Musk.

Performance Targets. The option is comprised of 12 equal “tranches,” each tranche representing 1 percent of Tesla's shares. A tranche vests only upon (a) the achievement by Tesla stock of the market cap level assigned to that tranche and (b) the achievement by Tesla of either one of two operational targets at levels discussed below.

(a) Achievement of Market Cap Targets. Each of the 12 tranches is assigned a market cap target. The market cap targets range from $100 billion to $650 billion, in $50 billion increments. A market cap target is achieved at the close of the trading day on which the average market caps for both the six-month period and the 30-day period ending on that day exceed the applicable target for the tranche. Once reached, the market cap target is considered achieved even if the market cap subsequently drops below that target level. The market cap targets are subject to adjustments to take into account transactions, including acquisitions, divestitures and spin-offs, that are considered material to the achievement of the targets.

(b) Achievement of Operational Targets. There are two sets of operational targets: revenue targets and EBITDA targets. (EBITDA is adjusted by removing any charge for stock-based compensation.)

(i) Revenue: The revenue targets range, in 8 increments, from $20 billion to $175 billion. A revenue target is achieved when revenue equals or exceeds that target for four consecutive quarters.

(ii) Adjusted EBITDA: The EBITDA targets range, also in 8 increments, from $1.5 billion to $14 billion. An EBITDA target is achieved when EBITDA, adjusted as described above, equals or exceeds that target for four consecutive fiscal quarters.

Like the market cap targets, the operational targets are subject to adjustments to take into account transactions, including acquisitions, divestitures and spin-offs, that are considered material to the achievement of the targets.

(c) Matching Achieved Market Cap Targets With Achieved Operational Targets. When a market cap target for an option tranche, as described above, is achieved it can be matched with either an achieved revenue target or an achieved EBITDA target, as described above. When that “match” occurs the tranche (representing 1/12 of the option) vests.

Following are three characteristics of the operational targets that should be noted:

(i) The two types of operational targets are not linked (they are simply two sets of targets) and an achieved target in either category can be “matched” with an achieved market cap target.

(ii) An achieved revenue target or an achieved EBITDA target, until used as a “match” for vesting purposes, continues to be available for matching even if revenues or adjusted EBITDA, as the case may be, subsequently fall below the achieved target level.

(iii) Once an achieved revenue target or an achieved EBITDA target is matched with an achieved market cap resulting in vesting it cannot be used again.

(d) Example. Assume that the market cap target of $100 billion is met and that the operational targets of $20 billion in revenues and $1.5 billion in adjusted EBITDA also have been met. The achieved market cap target can be matched with either of the two achieved operational targets—in this assumption either the achieved revenue target of $20 billion or the achieved EBITDA target of $1.5 billion. As a result, Tranche 1 becomes vested. Note that one of the two achieved operational targets was not needed in order to have a “match” for vesting purposes and will be available for matching with a market cap target achieved in the future. For example, achievement of a market cap target of $150 billion could then be matched with such achieved but unused operational target to result in vesting of a tranche.

Consequences of a Termination of Employment or Cessation as Chief Company Executive. If, for any reason, Mr. Musk's employment terminates or if he ceases to be the Chief Company Executive he will forfeit tranches of the option that are not yet vested. Chief Company Executive is defined in the award agreement as service as either (1) the Chief Executive Officer or (2) the Executive Chairman and Chief Product Officer.

Upon any termination of employment, Mr. Musk will have one year (or, if it occurs sooner, the date on which the original 10-year term of the option expires) to exercise any portion of the option that is vested and unexercised at the time of such termination. Upon cessation as Chief Company Executive, for so long as Mr. Musk remains employed with Tesla he will have until the option expiration date to exercise any portion of the option that is vested and unexercised.

Consequences of a Change in Control. Upon a change in control:

• the operational targets are disregarded and the achievement of the market cap targets is determined by using the greater of (x) the market cap immediately before the change in control and (y) the total value received by Tesla shareholders in connection with the change in control;

• Mr. Musk will forfeit tranches of the option that are not yet vested and do not otherwise vest, as discussed in the bullet point above, upon the change in control; and

• any vested and unexercised portion of the option will be exercisable until the option expiration date, whether or not Mr. Musk continues to be employed with Tesla.

Required Holding Period for Acquired Shares. Shares acquired upon the exercise of the option must be held for five years following their acquisition. Shares used for cashless exercise and shares used to satisfy tax withholding obligations are not considered dispositions for this purpose.

Non-Deductibility of Option

Under Internal Revenue Code §162(m) Tesla is limited to a maximum deduction of $1 million for compensation provided in respect of a taxable year to a “covered employee.” (Mr. Musk is a covered employee.)

Before the Tax Cuts and Jobs Act (TCJA), stock options were exempted from the Code §162(m) limitation. TCJA removes that exemption, and as a result, for taxable years commencing after Dec. 31, 2017, amounts realized by a covered employee upon exercise of a nonqualified stock option will be included in the compensation of such employee that is subject to the Code §162(m) limitation.

A binding written contract entered on or before Nov. 2, 2017 is grandfathered from the new rule. Since the Musk option was granted on Jan. 21, 2018 it will not be grandfathered and thus will be subject to the Code §162(m) limitation.

Conclusion

The Musk option, like many of Mr. Musk's achievements, is extraordinary. This is so whether measured, on the date of grant, by a traditional option valuation model (e.g., Monte Carlo, $2.6 billion) or by the value of the Tesla shares subject to it ($7.1 billion). If all targets are met (achievement of all 12 market cap targets and 12 of the 16 operational targets) the market cap of Tesla would be at least $650 billion. This is in the range of the market caps of companies with the largest market caps today (e.g., Apple, Alphabet and Amazon). At a market cap of $650 billion, Tesla estimates that the spread of the option would be approximately $55.8 billion (without taking into account adjustments for certain dilutions that might occur in the future).

Is this extraordinary option reasonable compensation for Tesla to be providing Mr. Musk? Would he produce the same results for Tesla without it? Or with something less? As noted above, the option was approved by well over a majority of Tesla shareholders (excluding Mr. Musk and his brother) who voted at the special meeting held to approve it in March. In a recent Delaware case, In re Tesla Motors Inc. Stockholder Litigation, C.A. No. 12711-VCS (Del. Ch. March 28, 2018), the Delaware Court of Chancery held that approval by a majority of Tesla shareholders of an acquisition by Tesla of another corporation, SolarCity Corporation, owned in part by Mr. Musk, did not prevent review by the court of the transaction under the “entire fairness” doctrine. The majority vote was reached without taking into account the vote of Mr. Musk. The Court of Chancery concluded that “it is reasonably conceivable that Musk, as a controlling stockholder, controlled the Tesla Board in connection with the Acquisition.” For this purpose, citing Delaware authority, the court states that a “controlling stockholder” includes one who exercises control over the corporation's business affairs notwithstanding being a minority stockholder. Thus, the court held that the majority shareholder vote did not eliminate the need for court review of the fairness of the transaction.

It should also be noted that Mr. Musk currently is serving in leadership roles at other companies, including as chief executive officer at a rocket company, SpaceX, and at two recent start-ups, The Boring Company (a tunnel-construction company) and Neuralink (a company in the business of artificial intelligence).

Mr. Musk has prodigious talents. We extend our best wishes to Mr. Musk and Tesla for results at Tesla that will produce full vesting of Mr. Musk's option and extraordinary value for the shareholders of Tesla, including Mr. Musk.

Joseph E. Bachelder III is special counsel to McCarter & English. Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of this column.