Issuing stock options in a startup can seem simple. But there are a series of crucial steps to follow to do this right, steps that founders do not always follow. This can lead to all sorts of problems down the road, including disputes with employees, increased scrutiny from investors, tax consequences and more.
These problems are avoidable, though. And they’re not that hard to avoid. They’re certainly cheaper through prevention than they are through trying to cure. This brings to mind the old slogan “you can pay me now, or you can pay me later.” In this setting, it means you can pay your lawyer a little to help do it right now or a lot more to help fix (or at least try to salvage) it later.
Related: Equity Grants to Startup Advisors
I’ll spare you all the reasons why startups use stock options. If you’re reading this, you’ve probably already decided it’s right for your startup. This guide is meant to focus on the mechanics of issuing options.
Related: What Type of Equity To Give Startup Employees
Start With A Plan
I don’t mean have a plan in a general sense here (though that doesn’t hurt). I mean have a formal, written equity incentive plan. Your lawyer can help the company get a basic plan in place as part of your initial incorporation, or later on when you’re ready to hire your first non-founder employee.
The equity incentive plan will be a fairly detailed document setting out the types of equity that can be issued under the plan, the number of shares authorized for issuance, treatment of stock on change of control, and much more.
Related: Stock Vesting On Change Of Control
It’s critically important to ensure both the shareholders and the board approves the equity incentive plan. The easiest way to do this is usually through one or more written consents, which your lawyer can put together for you.
Carve Out An Option Pool
As part of getting an equity incentive plan in place, you will carve out an option pool. You can think of as tucking away a certain percentage of equity to be issued to employees, advisors, consultants, etc.
Tip: 20% is a common size for option pools, but startups in their early stages may keep a smaller option pool.
It tends to be much easier to increase the option pool early on when the founders own the vast majority of equity in the company so an early stage startup might only reserve the number of options they anticipate issuing in the next few months. This dynamic will change as soon as meaningful investment is put into the startup, at which point you should expect the option pool to be a minimum of 10% (but likely closer to 20%).
Related: Startup Equity: Cutting The Pie
Your option pool will almost certainly change over time as you grow and particularly in connection with fundraising rounds, where the size of the option pool will be one of the points of negotiation with investors. This is an often confusing area for startups to navigate and deserves more in depth treatment in a separate post, which I’ll get around to eventually (you can give me a gentle nudge in the comments below if I haven’t gotten around to this in the next month or two).
Get The Board To Approve
OK, now you have a plan and you’ve allocated a certain number of shares to the option pool. You’ve found a great new hire, Michelle, and she’s agreed to accept an option to buy 50,000 shares. You’re the CEO and you don’t want to lose this superstar hire and so you send her an offer letter agreeing to issue her the option. So far so good, right?
Wrong. You overlooked a crucial step: getting board consent to issue the option. This is a critical piece of corporate governance that can’t be overlooked. The board of directors must approve option grants. Failing to do this can lead to a parade of legal and tax horribles that you and your employee will want to avoid.
Rather than agreeing to issue Michelle the 50,000 option in her offer letter, you should make clear that this equity grant is subject to the approval of the board. The board should then approve the equity grant at a strike price equal to fair market value, as determined by the board.
Have A Valuation
Stock option grants include an exercise price (or “strike price”). This is the price per share at which the recipient has the option to purchase the shares. The lower the exercise price, the more attractive the option grant is to a startup employee.
However, the tax code requires that the exercise price be equal to or above fair market value (“FMV”) on the day the option is granted. Setting an exercise price below FMV can expose the recipient to tax penalties, which is not a good retention strategy for a startup. This makes properly valuing option awards an important task for startups.
Related Post: What Startups Need to Know About 409A Valuations
The safest way to do this for startups is to have a current 409A valuation, which will set the FMV of the common stock. Having a current 409A valuation provides a safe harbor to startups insofar as it transfers the burden of proof to the IRS if it challenges the FMV determination.
Note: 409A valuations are considered “current” for up to one year unless there’s been a material event, like a new financing round.
If your startup has gone through a priced equity round, you should absolutely have a current 409A valuation to support any equity grants employees. If you haven’t had a priced equity round, you should still have a current 409A valuation to support any equity grants to employees, but there seems to be more risk-taking by startups at this stage, likely due to the expense.
Note: Valuation of employee equity is usually much lower than what investors will pay for preferred shares in a priced round.
Here’s the problem: there’s no way to hide this from prospective investors, acquirers, or anyone else you want to cut a large check. So, at the very least, be ready for any risk associated with this to be pushed back on the startup, but also be aware that it could jeopardize fundraising or acquisition efforts.
Do The Document Dance
Once the grant is approved by the board and an exercise price is set (hopefully supported by a 409A report), then you should have the recipient of the grant sign a stock option agreement memorializing and setting forth the terms of the equity award. In connection with this, you’ll want to also provide a notice of the option award and a copy of the equity incentive plan pursuant to which the equity award was issued.
Other documents may be appropriate depending on the specific circumstances, and so do make sure to check in with your attorney.
Comply With Securities Laws
Securities laws may not interest you. And that’s OK—as long as you’re working with a lawyer. But you should know enough to issue spot. That way you’ll know when to get your lawyer involved.
Securities (a stock option is an example of a security) are regulated primarily by the SEC and also by the states. The general rule is that when you issue securities, you have to register that issuance with the SEC and/or with one or more states—unless you can find an exemption.
Startups need to find an exemption when they issue securities. Registering with the SEC is prohibitively expensive and time-consuming. So, when you issue stock options, you need to find an exemption.
Rule 701 is the typical federal exemption startups rely on. So long as you’re issuing stock options to employees that have been approved by the board and issued pursuant to a written plan, your startup shouldn’t have problems complying with Rule 701, though there are dollar and percentage limits on awards under Rule 701 in a 12-month period and so you should always consult with your attorney in connection with securities law compliance.
The other reason to talk to your attorney about securities compliance is the patchwork securities regulations at the state level. California’s approach, for instance, requires a careful legal analysis to ensure that compensatory equity awards exempt from registration at the federal level under Rule 701 are also exempt under California’s securities law. Other states may have their own requirements to navigate, so again exercise caution and get help.
When it comes to stock option grants, it’s much easier and cheaper to set up a system up front to do this correctly than it is to try to troubleshoot down the road. Put differently, you can pay me now, or you can pay me later.