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Stock Options – 9 Best Practices to Get Started and Motivate Your Team

By Organizing your Startup as a Corporation you can Motivate Your Team with Stock Options

Stock options work like an incentive plan, the allow you to the ability to compensate and motivate your team, consultants, Directors, and advisors with valuable Equity Incentives.

If done correctly, Stock Options can help propel your company forward, because the individuals who receive Stock Options will have a vested interest in the company’s future success.  As their efforts and contributions help increase the company’s value over time, they will have the opportunity to participate in the resulting valuation upside as eventual equity owners of the company (e.g., when it is sold or goes public).

Stock Option Plans can get tricky, however, because the setup and management of a Stock Option Plan involve various business, HR, corporate, tax, accounting and securities law issues. Also, the approval and documentation of Stock Options and other Equity Incentives trigger various legal, tax and other requirements, which can be difficult to navigate if your team does not have the background and experience to do so correctly.

If you are considering adopting a Stock Option Plan for your company, then the following best practices will guide you in the right direction as you implement and administer this important equity incentive program:

1. Does Your Company Have the Right Stock Structure?

Your company will need to have the right Equity Capitalization structure in place before it sets up a Stock Option Plan and starts granting Stock Options.  First, you will need to make sure that you have enough Authorized Shares under your Certificate of Incorporation available to account for the new Stock Option Pool. For example, if your Certificate of Incorporation authorizes your corporation to issue 10,000,000 Authorized Shares of Common Stock, but 9,500,000 shares of Common Stock are Issued and Outstanding Shares, then you may need to increase the number of Authorized Shares under your Certificate of Incorporation in order to make room for the new Stock Option Pool.

Second, you will want to make sure that the Stock Option grants that you are issuing to grantees are perceived as valuable. For example, let’s say that your Stock Option Plan makes up 20% of the Fully-Diluted Shares of your company.  If your company currently has 1,000 shares of Common Stock issued and outstanding, then the 20% Stock Option Pool will have 250 shares of Common Stock and a 2% Stock Option grant (a sizable stock option award) will be exercisable into only 25 shares of Common Stock.  If, however, 2,000,000 shares of Common Stock are issued and outstanding, then the 20% stock option pool will have 500,000 shares of Common Stock and the 2% stock option grant now will cover 50,000 shares of Common Stock.  Even though the percentage ownership of the company is the same at 2%, the Stock Option recipient likely will perceive the Stock Option grant with the higher number of shares as a more generous compensation benefit, thus more motivation and incentive to help increase the value of the company.

If your Equity Capitalization structure needs adjustment to allow the adoption of a Stock Option Plan, then you may need to effect a Stock Split and/or increase the number of Authorized Shares available for issuance under your corporation’s Certificate of Incorporation.

2. Stock Options Require Rock Solid Documentation

Your company’s Stock Option program will involve many important documents, such as the Stock Incentive Plan, Notice of Stock Option Award, Stock Option Award Agreement and, in some cases, a Restricted Stock Agreement and Restricted Stock Unit (RSU) Agreement.  It is important that these documents comply with, among other things, the latest legal and tax requirements and reflect the specific features and benefits that make the most sense for your company.  For example, you will need to decide how to treat the outstanding Stock Options when the company is acquired.  Should the Vesting of the Stock Options accelerate immediately prior to the Acquisition or, in some cases, after Acquisition if employment is terminated within a certain window of time?  These documents will have important consequences in the future and require careful thought and preparation.

Also, proper documentation of the Stock Option Plan and other equity award documents is critical for your company’s compliance with certain federal and state securities law exemptions. For example, in order to qualify for the exemption under Rule 701 of the Securities Act of 1933, the equity awards must be, among other things, part of a written compensatory benefit plan (or written compensation contract).

3. Board and Stockholder Approvals are Required

The company’s Board of Directors and Stockholders will need to approve the company’s adoption of the Stock Option Plan documents and the pool of shares underlying the plan.  In particular, for Stock Options to qualify for the special tax treatment as ISOs (Incentive Stock Options), the Stockholders must approve the Stock Option Plan documents within 12 months before or after the Board of Directors adopts the Stock Option Plan.  In addition, the Board of Directors will need to approve each Stock Option or other equity award granted over time, with particular attention to, for example, the number of shares underlying each award, the Exercise Price, the stock Vesting parameters and what happens if the company is acquired.  Also, there are specific requirements for ISO awards granted to employees, including option recipients who hold more than ten percent (10%) of the company’s shares.

4. Stock Options are Securities – Don’t Mess with the Law

Stock Options are considered Securities, so your company will need to comply with the related state and Federal Securities Laws.  For example, if Stock Options are granted in California, then your company may need to file a Securities notice with the California Department of Business Oversight and pay a related filing fee that is calculated based on the number of shares under the Stock Option Plan and the current value of the company’s Securities. You also will need to check the requirements of other states where option recipients reside, as well as the federal exemption from registration requirements under Rule 701 under the Securities Act of 1933.  Failure to comply with these Securities law requirements can result in regulatory enforcement actions, as well as difficult due diligence issues when your company is raising money or being acquired.

5. Bring in Tax Help and the Bean Counters

Stock Option Plans trigger a number of accounting and tax issues.  Your company will need expert professional support to understand and comply with the tax-related requirements and consequences of the different types of Stock Options (e.g., ISOs and Non-Qualified Stock Options) and other awards such as RSUs and Restricted Stock grants.  Your company also will need to expense properly the Stock Option grants and other equity awards, therefore requiring proper accounting support.

6. Keep the Strike Price in the Strike Zone

The Board of Directors typically will grant Stock Options with an Exercise Price (or Strike Price) equal to or greater than the fair market value of a share of the company’s Common Stock at the time of grant.  For example, ISO treatment requires that the Exercise Price of the Stock Option to equal (or exceed) the fair market value of the underlying stock at the time of grant.  Your company should consider obtaining an independent valuation of its stock, in order to (i) support the Board’s determination of fair market value for the Exercise Price, (ii) comply with the “safe harbor” provisions of Internal Revenue Code Section 409A and (iii) avoid potential tax penalties to the Stock Option recipients if the Exercise Price later is found to have been set below the fair market value.  An independent valuation that complies with Section 409A will set the Exercise Price for the next 12 months unless there are significant developments or transactions for your company, which require a valuation refresh (e.g. financing or material commercial deal).  We typically see valuation experts charging anywhere from $2,000 to $5,000 for 409A valuations of Early-Stage Companies.

7. Track Your Stock Options – Future Deals Depend on the Details

Many companies fall short when it comes to managing their Stock Option Plans and following the various approval, documentation and compliance requirements.  Unless your company has personnel with solid experience in Equity Compensation matters, your company should engage outside support to manage and track the documents and details, including changes to your Cap Table and Vesting of awards.  Your company also will need a solid system to record and track the outstanding Stock Options, so that you can review stock Vesting levels, determine the remaining shares available in the Stock Option Pool and manage Employee terminations and option exercises over time. A mismanaged Stock Option Plan may create Due Diligence and other issues for future Financing and Acquisition transactions, so start managing and documenting properly your company’s Equity Incentives from the beginning.

8. Don’t Make Equity Promises You Can’t Keep

Equity promises, whether for share grants or Stock Option awards, are dangerous because they often are made verbally and casually without solid documentation to support them.  Your company should have a disciplined process in place to determine, approve, communicate, document and track its Stock Option and other Equity awards.  The devil really is in the details and all Stock Option Plan documents, and company documents referring to Stock Option awards (e.g., Offer Letters, consulting agreements, Advisory Board Member Agreements, etc.), should be drafted with precision and appropriate caveats.  For example, an Offer Letter should explain that the Stock Option award will be subject to formal Board approval and then will be documented with separate Stock Option documents that will govern the Stock Option award relationship.  In addition, it is important to remember that each Stock Option award is not made in isolation.  Your company will need to evaluate and plan its future equity awards as part of a complete Equity Incentive program that makes sense for your company.  And remember that people talk to one another and you may need to be prepared to explain why certain employees and other contributors received different Equity Incentive awards.

Also, verbal equity promises may get lost in translation and may come back to haunt you. For example, if you promise someone 1% of the company, does that mean 1% of the company’s Fully-Diluted Equity Capitalization or 1% of its Issued and Outstanding Shares? The difference between these two calculations could be significant. Additionally, failing to follow up verbal equity promises with proper documentation could create ownership and Due Diligence issues in the future if you move towards a Financing or Acquisition transaction. When money is on the table, you want to make sure that your Equity Capitalization (and all equity awards) is solid, so that no one comes back and claims that the company did not issue an Equity award that was promised in the past.

9. Educate to Motivate Your Team

Stock Options are designed to motivate your team and other “service providers” of the company by providing them with valuable Equity Incentives awards that align their interests with those of the Stockholders.  This motivation falls short, however, if the Stock Option recipients do not understand how they work or that they are valuable.  In one extreme case, the Employees of a company refused to sign their Stock Option award documents, because they thought that the documents obligated them to buy the stock (and who knows what else) in the future.  If your company intends to invest the time and resources to set up and manage a Stock Option Plan, then the Stock Option recipients will need to understand the mechanics and value of their Stock Option awards.  Without the appropriate level of education and explanation, your company will miss out on the intended incentives, motivation and stockholder alignment to create a more valuable company.

It is great to see companies that reach successful exits, whether through Acquisition or IPO, especially when the Employees and other important contributors can participate in the financial upside with their Stock Option awards.  While looking to the future, you likely will need to set up your company’s Stock Option Plan early on, because you will need to use the Stock Option awards to bring the right people into your company and provide them with extra Incentive Compensation.  And remember that the Stock Options are more valuable (i.e., have a lower Exercise Price) and have greater upside potential when granted before your company takes off and starts to achieve great things.

Weigh your options carefully and let us know how your Stock Option program is helping your company attract the right people and achieve success.

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