Laying the Legal Groundwork: Understanding Stock Option Grants

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Stock option grants are an excellent way to strengthen your employee compensation package. However, they are also a tricky legal topic that can be extremely costly to get wrong. In many areas, a business doesn’t need to be incredibly strict or airtight, but when it comes to human resources, legal issues, accounting, and finance, there are few margins for error.

Stock option grants are a way in which a startup uses their equity for compensation instead of or alongside using cash to page wages. While not technically shares of stock, stock option grants, when granted, are an employee’s right to buy a certain number of company shares at a fixed price, typically referred to as a strike price, grant price, or exercise price.

In this article, we’ll review how equity is used in the early days of a startup to compensate employees and make it possible for them share in your company’s success as it grows in value. We’ll also review the basics of a stock option plan, the type of stock options available, potential ideas for terms, and what to do about stock options after employee termination.

Early Days Compensation

Everybody wants to get in on a startup early on. By providing equity instead of a higher salary you offer employees the ability to potentially gain significantly more than what their salary could have been in the long run, incentivizing them to join your company despite the potential risks.

Additionally, by providing equity instead of or alongside salary, the startup can possibly save some of its much needed cash required for operations. 

Simply put, stock options exist as a part of your compensation package. Many times the stock only has nominal value in the beginning, and if the startup fails, they are worth nothing in the end.

However, if a startup succeeds, those shares can be anything from a nice windfall to lasting generational wealth depending on how well the company performs. The chance of striking it rich is part of the drive for many to join startups in their earliest days.

Stock Option Plans

Understanding how to structure your company’s stock option plan can make granting equity a significantly easier process.

When the company’s ownership is being divided up, each of the founders and the investors will have a certain percentage of ownership of the company. If you think of the stock as percent ownership in the company, then visualizing it as a pie is an easy way to understand the segmentation. 

One hundred percent of the pie is the maximum amount, and it cannot exceed this. The founders of the company own large pieces of the pie, while investors will often own a smaller percentage.

It is often recommended to reserve 10 to 20 percent of the pie to issue later on. If you need more than the pre-allocated 10 to 20 percent, then everyone who is a shareholder at the time will have to dilute their amount of shares to make up for the difference.

Types of Stock Options

After establishing a plan, you’ll want to decide what type of stock options you’ll offer as an employer, or what stock options you’ll want to tax advantage of as an employee: incentive stock options (ISOs) and non-qualified stock options (NSOs).

ISOs are different from other types of options because you don’t usually have to pay taxes when you buy, or exercise, the ISOs at the fixed stock price. Simply put, this means they qualify for special tax treatment.

Additionally, you can possibly end up paying a lower tax rate if you meet certain requirements when dealing with ISOs. This goes into effect if you hold your purchased shares for one year or more, allowing you to pay capital gains tax on the increase in share value, which is lower than ordinary income tax.

NSOs, on the other hand, do not qualify for special tax treatment for the employee. With NSOs, you pay taxes both when you buy shares, or exercise the option, and sell them. You end up paying more taxes when dealing with NSOs.

Another option some companies use are restricted stock units (RSUs). However, these are different than stock options and are treated differently for tax purposes.

Further Details on Vesting and More

Most employee stock options come with a range of rules and stipulations. There are vesting periods and much more to consider when creating your company’s equity incentive plan. The specifics should start with the offer letter.

A strong recommendation is to include a number of shares in the letter instead of a percentage ownership. This can prevent issues of when the stock is officially granted, whether it is going to be diluted or not, or other complex considerations. Having a simple number of shares can make this process more painless and easier to navigate.

While it is normal to explain what the numerical value of shares represents to the company’s percentage of shares, sticking to a numerical value is often advantageous in a contract.

Potential Ideas for Terms

Every company is different. This means that while some general suggestions will work for some companies, others would find them to be a poor fit for their needs. When creating general terms for stock options, some suggestions include:

  • A one year cliff.
  • A four year vesting schedule.
  • A fair market value (FMV) stock exercise price subject to board approval.
  • Delineating between preferred and common stock.

By integrating these terms and further modifying them to suit your company, you can create an agreement that fits your needs.

Options After Termination

Whether an employee leaves voluntarily or otherwise, figuring out your rules for exercising stock post-termination is important. While ISOs and NSOs theoretically expire after 10 years, you might consider enforcing a post-termination exercise (PTE) period that shortens the length of time a former employee has to exercise options.

Some companies provide a short-term window of 30 days in which you must exercise your options, while others provide up to three months. Sometimes providing extension options that increase the amount of time for exercising your stock is a great way to reward employees who leave on good terms.

These are all options that should be discussed with legal and tax counsel so that you can find what plan suits your needs most appropriately.

Establish an Equity Incentive Plan for Your Employees

By working with your legal and tax team you can establish an equity incentive plan that gives your employees additional benefit while keeping your legal risks to a minimum.