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Legal INCubator Playbook: Stock Options

Each Legal INCubator Playbook focuses on the key concepts and decision points that you need to know about for a specific startup topic. With practical guidance summarized for your use, you will be prepared to take informed action as you start, fund, grow and exit your startup.

What It Is:

A Stock Option provides the holder, or the Optionee, with the right to buy a certain number of shares of Common Stock at a fixed Exercise Price over a certain period of time, so long as certain conditions are met.  As the value of your company increases, the Stock Option becomes more valuable as the difference grows between the value of the shares of Common Stock underlying the Stock Option and the Exercise Price at which they can be purchased (sometimes called the Spread).

Why It’s Important:

With Stock Options, your Startup can provide additional Equity Compensation to hire and retain employees and engage consultants and advisors, thereby allowing you to retain two very important assets: talent and cash. When done right, and by including appropriate Vesting conditions that require the Optionee to remain in service to the company as a condition to holding and/or exercising the Stock Option, Stock Options help align the efforts and activities of your team with the long-term success of your company. Simply, as the value of your company continues to increase, the Optionees have the opportunity to benefit financially as their Stock Options become more and more valuable.

Key Things to Know:

Stock Option Pool

You will need to determine the number of shares of Common Stock to be included in the Stock Option Pool. Depending on the industry and your need to attract talent, the size of the Stock Option Pool typically ranges from 10% to 25% of the Issued and Outstanding Shares of Common Stock. The Stock Option Pool will affect your company’s Equity Capitalization, given that the number of shares of Common Stock in the Stock Option Pool will increase the Fully-Diluted Equity Capitalization of your company. Also, the number of Issued and Outstanding Shares of Common Stock of your company will increase with each exercise of Stock Options.

Stock Option Documents

Your company will need to prepare a Stock Incentive Plan (also known as an Equity Incentive Plan) that will govern the award and administration of Stock Options.  Each individual awardee also will receive a Notice of Stock Option Grant and related Stock Option Award Agreement. Note that the Stock Incentive Plan typically will allow for the award of Restricted Stock grants, Restricted Stock Units, and other Equity Incentives.

Corporate Approvals

The Board of Directors and the Stockholders must approve the Stock Option Plan, and the Board of Directors must approve each individual Stock Option award.

Exercise Price

When the Board of Directors approves each Stock Option grant, it also must approve the related Exercise Price, which should equal the then Fair Market Value of a share of Common Stock. Best practice is to comply with the requirements of Section 409A of the Internal Revenue Code.

Securities Law Compliance

Remember that Stock Options are considered Securities and your company will need to comply with the applicable Federal Securities Laws (e.g., Rule 701) and state securities laws (or Blue Sky Laws). Future Investors and Acquirers will want to see that your company has complied with its legal requirements.

Tips and Next Steps:

Stock Option Grants

For each Stock Option award, you will need to determine how many shares will be covered, taking into account, among other things:

  • the aggregate size of the Stock Option Pool;
  • how many shares remain in the Option Pool after taking into account all existing and proposed grants;
  • the importance of the hire or engagement to the company;
  • the company’s ability to compensate the team member through other means (e.g., cash);
  • the ability to align the company’s interests with the grantee through equity ownership and vesting conditions; and
  • the size of the grant relative to prior and future Stock Option awards.

It is important to have a thoughtful approach to Equity Compensation, which recognizes the relative roles, responsibilities and importance of the various grantees.

Stock Option Vesting

Each Stock Option should be structured to motivate employees, consultants and advisors to perform better and create Stockholder value in alignment with the company. The Vesting of the shares underlying each Stock Option award should be tailored to enhance performance incentives while creating more stickiness for key team players to stay with the company.

Standard-Cliff Vesting should be considered as an initial alternative – 25% of the option shares vest after 12 months (i.e., after a trial period) and the remaining 75% of the shares vest in equal monthly amounts over the following 36 months.

The Vesting parameters can be adjusted and customized for each situation, but we recommend that you keep each Optionee’s Vesting conditions simple, straightforward and understandable. In most cases, we recommend that you stick with Time-Based Vesting and avoid complicated Performance-Based Vesting that could be subject to interpretation and finger-pointing and more likely result in a dispute.  You also will need to determine whether, and for which Optionees, the Vesting of each Stock Option award will accelerate upon a Change of Control  (also known as Accelerated Vesting) and if the Early Exercise Feature will apply.

Stock Option Administration

Most Startups do a poor job at Stock Option administration for many reasons, including because it involves many varying terms, important Equity Capitalization matters and contract preparation. Also, properly administering a Stock Option program requires that your company navigate and comply with various corporate, tax, securities and other legal requirements.

It is very important to track the Stock Option grants on your Cap Table on a real-time basis, because, if exercised, these Stock Option awards will alter the relative Equity Ownership of your company and because, if terminated, the shares underlying these Stock Option awards should revert to the unallocated Stock Option Pool and become available for grant to another Optionee.

If your company does not have the administrative skills and experience to perform this work correctly, then you should outsource this work and get it done correctly. Again, most Startups fall short when it comes to managing the various moving parts of a Stock Option Plan, so consider working with experts who do this Stock Option work regularly. They will raise the right questions and issues and help you get to the right answers and results.

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