STOCK OPTIONS FOR EMPLOYERS
I went through the basics of stock options in an earlier article. Read that article first. As I always stress it's important to understand the fundamentals of what you're doing--doesn't matter what it is.
Now I want to get into the more nitty-gritty details of stock options.
I'm going to show you how to prepare and grant stock options. You need professional legal assistance/corporate attorney to do this. This is not an area to mess up on. Doing this yourself is NOT what this guide is for. Use this article to UNDERSTAND the process.
This article is for employers, if you're a stock option recipient then you can skip this piece and read the other.
Table of Contents of Stock Options for Employers
A. Issuing Options--the Pregame
1. Decide between Issuing Restricted Stock or Stock Options
2. Make Sure that the Startup Uses Common Stock for Options
3. Set Aside Equity for Options
4. Know How Much Equity to Grant to Individuals
5. Decide What Type of Options to Grant
6. Plan for Securities Laws Issues
B. Granting and Exercising the Options Step by Step
1. The Stock Option Documents
2. Steps for Granting the Option
Step 1. Set Aside Enough Stock
Step 2. Prepare the Stock Option Plan
Step 3. Adopt the Stock Option Plan
Step 4. Prepare the Stock Option Agreement & Stock Option Grant
Step 5. Prepare any requisite disclosures
Step 6. Grant the Option to the Recipient and Execute the Agreements
3. Steps when Option is Exercised
Step 1. Double check everything
Step 2. Make sure that the recipient is eligible
Step 3. Make sure the shares have vested
Step 4. Make sure that the timing is appropriate
Step 5. Company should repurchase if it desires
Step 6. Handle tax matters
Step 7. Provide any disclosures required
Step 8. Receive payment from the option holder
Step 9. Issue stock certificates
C. Tips for Startups Issuing Stock Options
1. Don't be amateur regarding dates
2. Set the exercise price to the FMV
3. Vest the Options
4. Make sure the option pool is the right size
5. Be Conscious of clawbacks and repurchase rights of vested shares
6. Make Sure to Have a Right of First Refusal
D. Conclusion
A. Issuing Options--the Pregame
The stock options described in this article concern C-Corps. If you've set up your startup as an LLC, you are either intentionally going for something unique (which is fine . . . maybe); or you messed up (which is not good, but is fixable.) In the latter case, you will need a more complex set up or convert from LLC to C-Corp.
The pregame part of all of this concerns making decisions as to what and how much stock to allocate for options. Here's where I tell you how to figure that out.
1. Decide between Issuing Restricted Stock or Stock Options
Restricted stock and stock options are the two chief ways to use equity (i.e. ownership of the company) for compensation and incentive purposes. When making a hiring, the startup needs to decide which is better to use.
Restricted stock: Restricted stock in this context is stock subject to vesting. It is actual stock and if the recipient leaves before the stock has vested, then the stock is forfeited to the company.
In other words, the company gives an employee stock of the company. If they leave before a certain amount of time has passed, the stock goes back to the company.
Stock option: An option, as mentioned before, is not actual stock. It is the option to purchase stock at a specified price at some point in the future.
Which to use: So should the company issue restricted stock or stock options? Here's what you should do:
If it's very early in the life of the company, the company doesn't plan on making too many hires, and the recipient is going to be a key employee, then go with restricted stock--it's simpler and cheaper to put into place; otherwise go with stock options.
2. Make Sure that the Startup Uses Common Stock for Options
I've already told you before that companies have different types of stock.
The two types you're going to see are common and preferred. Common is the basic unit. Preferred stock is stock that comes with certain rights above common such as anti-dilution rights and getting paid before common in case the company gets liquidated. Investors get preferred stock. Founders get common stock. When we're dealing with stock options what we're talking about is using COMMON STOCK.
Again: the stock options to be dished out for employees, directors, consultants, etc. are for common stock. No anti-dilution rights. No fancy rights. Just the same basic stuff as what founders have.
3. Set Aside Equity for Options
A certain amount of equity of the company should be set aside for hirings. The stock set aside for option granting purposes is called the option pool. But how much of the company should be set aside for option granting? How big should the pool be?
A rough aggregate of 20% of the company for a post Series A company is normal. Lower than 20% is good because it means less dilution for founders and it is better for valuation purposes (I discuss option pools and how they effect valuations in a different piece.) Note however that you shouldn't make the pool size too small because you need enough equity to properly issues the options to employees.
4. Know How Much Equity to Grant to Individuals
The earlier you are in the stage of your startup, the more equity you will be giving out to each employee. This is because (1) the startup often doesn't have the cashflow to offer super competitive salaries the earlier it is in the lifecycle of the company; (2) the big benefit of working for a startup aside from working on something very novel is the potential upside in a later sell-off. Employees want to be able to share in this upside by having equity. It's a risk/reward thing; and (3) the earlier the employee, the more instrumental and more important they are in creating what the company will become.
So the question is then, how much equity to set aside? There are no set numbers and this is a rough guide. For a company that has just done a Series A financing, here is the range of equity granted when the person is hired.
CEO: 5-8%
CTO: 2%-3%
COO: 2-4%
CFO: 1-2%
Board Member: 0.4-1.25
Lead Engineer: 0.5-1.5%
Senior Engineer:0.33-0.66
Junior Engineer: 0.2-0.33
5. Decide What Type of Options to Grant
The two forms of stock options are Incentive Stock Options (ISO) and Non-qualified Stock Options (NSO.) It will be easier for the employer to issue NSOs. As I've mentioned before, NSOs are better because they are simpler, more flexible, and can be used in more situations.
6. Plan for Securities Laws Issues
Company stock is a type of security. So securities laws come into play. A company cannot issue securities unless the securities offering is registered with the SEC (an incredibly timely and expensive process) or there is an exemption from registration.
What does this mean?
It means the company can't do a stock option setup unless you can find an exemption from registration (or register--which you're not going to do.) So what can the company do?
The company can use Rule 701 for an exemption.
Rule 701 is the federal "exemption for offers and sales of securities pursuant to certain compensatory benefit plans and contracts relating to compensation."
Note that this rule is regarding compensation. A startup can't use this rule for capital raising purposes. This rule is used so that the company does not have to register and file a bunch of shit with the SEC when issuing stock options.
Rule 701 in essence is about three things:
1. Who:
Rule 701 will require that the person who will receive the option is an employee, director, general partner, officer, consultant, adviser, or other. Special rules may apply that require the recipient to be a natural person who provide bona fide services to the startup.
2. How much:
The aggregate sales price or amount of securities sold in reliance on this section during any consecutive 12-month period must not exceed the greatest of the following:
(i) $1,000,000 [which is the number of options granted multiplied by exercise price]
(ii) 15% of the total assets of the issuer
(iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on this section
3. What disclosures must be made:
If the aggregate offerings is less than $5 million, then the startup only needs to provide a copy of the compensatory benefit plan or agreement. A short summary of risks, financials, etc. can be provided as well.
If the aggregate offering is for $5M or more, then the startup needs to provide financial statements, statement about risk factors of the investment, and material terms of the plan.
So Rule 701 is the securities exemption that you will be relying on. Additionally, you will also need to make sure that you abide by state regulations. Offers and sales under 701 must still comply with state securities aka "Blue Sky" laws.
B. Granting and Exercising the Options Step by Step
Enough with the theory. How is granting and exercising of the options actually going to go down?
Basically like this: the startup is going to set aside and reserve a certain number of common stock for issuing options; it's going to adopt a stock option plan that describes the terms and conditions of stock option grants. Then the startup will grant stock options to individuals. When it comes time, the individuals will exercise their options and the startup will issue stock to them.
I'm going to start off by telling you what documents are going to be used to accomplish all of this, and then go through the actual steps.
1. The Stock Option Documents
The startup will need a number of documents in order to grant stock options:
(1) The Stock Option Plan - overarching plan for this whole set of grants to be awarded to various recipients.
(2) The Stock Option Agreement - agreement between each individualized recipient and the company that details the type/number of stock purchasable
(3) Exercise Agreement - agreement between each individual recipient and the company that details the manner of exercising the option
Supplementary documentation:
Board and shareholder approvals/resolutions; any disclosures or documentation required by securities laws.
2. Steps for Granting the Option
Step 1. Set Aside Enough Stock
10% - 30% of the company's stock should be set aside for stock options. Lower is better for founders. Investors won't really care if it's too high because this amount will be diluting the founders and other common stock holders, not the investors.
This is the option pool. For the exact amounts to grant per individual, look at the table up above.
Step 2. Prepare the Stock Option Plan
The company needs to draft and prepare the Stock Option Plan. This does the plan do?
The option plan details: the purpose of the plan; definitions that will be important to both the plan and the grant; the stock that can be granted (including the maximum number); who and how the plan will be administered; who will be eligible for the options; how long the plan can be in effect for; how the options will be exercised in general; and other matters.
Step 3. Adopt the Stock Option Plan
Have stockholders and the board vote and adopt the plan.
Step 4. Prepare the Stock Option Agreement & Stock Option Grant
Recall that the Stock Option Agreement is the individualized agreement that is given to each employee that is getting an option. The Stock Option Agreement will specify the number of shares purchasable and the time table.
a. Make sure that the exercise price is at the fair market value of the stock.
You do this by receiving an outside, third-party 409A valuation.
b. Have the Board approve each grant
c. Make sure that the recipient is allowed to receive the options
Remember that ISOs can only be granted to employees.
d. Abide by Securities Laws regulations and mathematical limits (see above.)
Step 5. Prepare any requisite disclosures
See above in the Securities Laws section to see if you need to make any disclosures.
Step 6. Grant the Option to the Recipient and Execute the Agreements
The agreements need to be signed. Plan administrator (typically part of the board of the company) and the recipient should sign the Stock Option Agreement. Have the spouse of the recipient (if applicable) sign as well. Give a signed copy of both the stock option plan and the stock option agreement to the recipient.
3. Steps when Option is Exercised
Step 1. Double check everything
a. Board/shareholder resolutions
Remember that the Stock Option Plan/Stock Option Grant need to be approved.
b. Dates and signatures on the documents
This should go without saying but crappy cut and paste jobs can create problems. Make sure it's all correct.
c. Securities law compliance
Make sure that you are under the mathematical limits of Rule 701 and that you comply with any state Blue Sky securities law issues.
d. Shares of stock that the recipient wants to purchase
An employee may have been given a number of stock option"s" (as opposed to a stock option) each with different exercise prices. Know which stock the option holder wants to purchase and at what price.
Step 2. Make sure that the recipient is eligible
Has the person been terminated or is for some other reason ineligible to exercise the option?
Step 3. Make sure the shares have vested
Check the vesting schedule and the employee's employment agreement and time table. Have the shares properly vested? If the option was not subject to vesting, is the option exercisable at this time?
Step 4. Make sure that the timing is appropriate
Is there an exercise lock up or is the option otherwise not allowed to be exercised at this time?
Make sure the option hasn't expired.
Step 5. Company should repurchase if it desires
Some stock option documentation allows for the company to repurchase options. If this is the case, does the company want to act on this at this time?
Step 6. Handle tax matters
The startup needs to make proper tax withholding. The tax withholding needs to consider not just the FMV of the stock when it was initially granted (which should have been done before) but also the FMV of the stock currently.
Step 7. Provide any disclosures required
This will be as required by securities laws as mentioned above.
Step 8. Receive payment from the option holder
Accept the payment (as calculated with the exercise price + tax withholding.) Don't accept a promissory note from the option holder. This can cause problems later especially if the stock tanks.
Step 9. Issue stock certificates
If everything has gone smoothly and everything is in order, issue stock certificates to the employee.
C. Tips for Startups Issuing Stock Options
1. Don't be amateur regarding dates
Companies often confuse dates on the employment agreements, option agreements, and the like. Make sure all the dates are synchronized and make sense. Don't be amateur about it.
2. Set the exercise price to the FMV
Don't try to do favors or be fancy and set the exercise price to less than the FMV at the time of granting. You'll just complicate things. Use an outside third-party to help set a valuation on the price.
3. Vest the options
Options should be vested and the vesting schedule should be reasonable. Longer is more favorable to the company. Shorter is more favorable to the employee. Vesting schedules are generally set for 3, 4, or 5 years. A reasonable vesting schedule is 4 years with a 1 year cliff with single or double trigger acceleration. Recall that one of the primary reasons for granting options is to incentivize people to stick around. Using vesting in order to accomplish this.
4. Make sure the option pool is the right size
If the option pool is too large, it will negatively affect the founders. The pre-money valuation of the company for a priced financing round takes the option pool size into consideration. See what talent you already have and if you feel like you already have great talent and people in key positions, make the pool smaller (e.g. 10% instead of 30%.)
5. Be Conscious of clawbacks and repurchase rights of vested shares
Clawbacks and the ability to repurchase vested shares are powerful rights. Basically, if the employee leaves (or goes to work for a competitor or the like), the company can repurchase the shares. These types of rights come in various flavors. There are forms that require the employee to surrender their gains. Do the stock options you granted have this right set aside for the company? If so, that might be great for the company, but it also might be a total turn off for a potential employee. Make sure you strike a good balance between what is reasonable and unreasonable.
6. Make sure to have a Right of First Refusal
A Right of First Refusal is a share transfer limitation. Basically, before the holder of any shares may sell or transfer any shares, the startup should get first dibs and be able to purchase the stock. The company gets the right of "first" refusal. Any shares that an option holder gets to buy should have this limitation.
D. Stock Options for Employers Conclusion
Re-read this article as necessary--get a good idea for how all of this goes down, get it done, and keep moving!