Issuing stock options – 9 things to know before you do

Are you looking to set up your first employee stock option plan? It is an exciting time for any
business, but there are potential pitfalls attached, and as with so many other situations the most
effective way to handle any mistake is to not make it in the first place. With that in mind, here are
nine points you should consider before formally unveiling your plan.

1. Why stock options?

This is a key point to be clear on at the outset. What are you looking to achieve? Will issuing stock options to your people help to accomplish those goals? More specifically, why stock options and not common stock? That latter question points to a key consideration that should not be overlooked no matter what the plan. Yes, it must work for the business, but unless it also proves attractive to employees, it may not perform as you hope.

While the topic of stock options vs common stock is worthy of lengthy treatment in its own right, here we’ll make do with stating the core point; namely, stock options are usually more attractive to employees. With stock options, employees literally receive an option to buy shares at a later date, whereas common shares are formally awarded on day one and therefore trigger a tax obligation, even though the relevant vesting terms will most likely prevent recipients from accessing those shares in the short-term. This can create a headache when it comes to settling any tax bill. Meanwhile, stock options are not taxed at issuance, with the first bill becoming due at the point of exercise.

2. Board Approval

This might seem like stating the obvious, but board approval will be required before granting stock options to employees. The norm is that unanimous written agreement will be needed before you can legally proceed.

3. 409A valuation

IRS rules dictate that any stock options issued must be priced equal to or greater than the fair market value (FMV) of company shares at the time of the grant. The company doesn’t get to simply nominate a value, instead the IRS insists that an independent third party conduct an appraisal, i.e., a 409A valuation. This value will then be accepted as accurate by the IRS. However, companies need to be aware that 409A valuations do not remain valid indefinitely. Instead, a new valuation will be need to be established every year or so or in advance of a fresh funding round.

4. Option pool

Prior to awarding any options, you need to be clear on what percentage of company equity is going to be set aside for this purpose. An option pool tends to be in the 10-20% range, with new startups typically beginning with a much lower percentage and increasing it over time as they attract outside investment.

It is also important to note that the number of options issued should never exceed the total set aside in the option pool. In the event of grants exceeding the agreed size of the pool, those options will be deemed invalid.

5. Who and how much?

Another key point to be clear on before committing to any award is what employees will be included and how many options they will they receive. It is common practice to create tiers based on the seniority of the position held. Individual companies might structure tiers differently, but generally C-Suite executives will rank highest and below that companies may at their own discretion single out senior managers and individuals deemed to merit inclusion.

Once the tiers have been established, you can then decide which groups receive what percentage of the available options. Where you are in the start-up lifecycle will influence these decisions, but the C-Suite will usually be earmarked for the lion’s share.

6. Put it in writing

As a general rule in business, it is better to put things in writing, and that also applies to employee equity plans. In practice, this will end up as a detailed document, specifying the rules and terms of whatever plan or plans you introduce, covering, for example, the types of equity to be issued, the number of shares involved, and how that stock will be treated in the event of the business being sold or individuals leaving.

For stock option awards, it is standard to have recipients sign a formal agreement document setting out all relevant terms.

7. Leavers

No matter how positive and rewarding the work environment, it is almost inevitable that certain individuals will at some point choose to move on. It is also possible over time that you may need to let some employees go, for poor performance or disciplinary reasons etc. Whether we’re talking about good leavers or bad leavers, you need to establish clear guidelines on what happens when people depart.

When good leavers exit the company, it is common for them to hold options that have vested and return those that are unvested. In the initial agreement, companies will typically include a clause that gives them the right to buy back vested options in the event of a recipient moving on.

Arising from the circumstances of their departure, bad leavers will usually receive less favorable treatment. Not only will they hand back unvested options, it is also likely that the terms set out in the agreement will allow the company to reclaim already vested options without having to offer any compensation.

8. Vesting

Vesting schedule indicates how long employees will have to wait before being able to complete the transaction and turn their options into shares? Again, it’s not a one-size-fits-all, but a typical approach would be to include a one-year cliff period at the outset before vesting begins, with a view towards ensuring employees remain with the company for at least that period of time after receiving the award.

From there, the agreement might make provision for 25% of options to vest every year over a four-year period. Under those terms, an individual would have the right (but be under no obligation) to exercise one-quarter of allocated options every year for the life of the agreement.

9. Incentive Stock Options (ISOs) vs Non-qualified Stock Options (NSOs)

It is also important that you be clear on the differences between ISOs and NSOs. There is more leeway around who can be awarded NSOs, but a trade-off with that flexibility for recipients is that ISOs are treated more favorably for taxation purposes. More specifically, NSOs can be awarded to consultants as well as employees, whereas ISOs are just for employees, and NSOs are taxed at exercise and again at sale, while ISOs are taxed only when individuals sell those shares. Also, ISOs can be passed on in the event of the initial recipient dying, whereas NSOs cannot be transferred.

Depending upon the circumstances, one type will be more attractive to those you seek to incentivize. Strictly from the company perspective, NSOs are favorable, as tax benefits can be claimed by the issuer when recipients exercise their options.

Here we have highlighted nine points related to granting stock options to employees. Depending upon the specifics of your circumstances, you might also need to consider other issues. If you want to discuss this or any other employee equity compensation-related issues, contact us today and speak with one of our experienced personnel.