A 4-step process for startups’ stock option planning

What are stock options in a startup?

Startup’s stock option are a popular type of equity compensation plan. It allows employees to purchase a specific number of shares of the startup's stock at a predetermined price (known as the exercise price) within a particular timeframe. Stock option grants can incentivize and retain employees, as they have the potential to increase in value as the startup grows and becomes more successful.

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How does a stock option plan work?

The exercise price is typically set forth in the employee stock option agreement at the stock's current market value at the time the option is given. Once employees exercise their options, they purchase the stock at the exercise price and can either hold onto the shares or sell them in the open market. They can sell the shares at a profit if the stock price has gone up since the option was granted. In short, stock option plans align employees' interests with the startup's and can potentially increase overall shareholder value.

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Getting your startup's stock option planning process right

It’s a lot cheaper getting your startup’s stock option process correct from the beginning than fixing mistakes later. Fines, legal exposure, upset employees, and delays preparing for IPO or acquisition are just some of the consequences of screwing this up. To avoid problems like these, founders need to understand and own their startup’s stock option process.

Your lawyers can provide support in setting up your stock option plan and taking care of specific legal tasks, but only you know when your hiring plan changes or when you need to make an offer to a new employee.

You can have the best legal team on earth, but they can’t read your mind. — John Bautista, Partner at Orrick, Herrington & Sutcliffe LLP

To a busy founder, owning this process can seem like yet another distraction from building a great company. However, this doesn’t have to be complicated. This post outlines an effective four-step stock option planning process:

1. Setup

2. Maintenance

3. Making Offers

4. Finalizing Stock Option Grants

By following these four steps, you can avoid common stock option plan mishaps.

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1. Setup

There is an upfront investment you’ll need to make in order to issue options to your first set of employees.

• Develop your philosophy. Your stock option plan is an expression of your startup philosophy. How you design and communicate this important incentive to your future employees is worthy of discussion with your co-founders, board and advisors. How much of your startup do you plan to share with early employees? How do you want to reward people who join later? How standardized do you want your stock option grants to be? How do you want to balance cash versus equity compensation?
• Paper it. Adopt your stock plan and option agreements and get board and stockholder approval.
• Make it official. Work with your lawyers to obtain all relevant state permits for your option plan. Employee stock option regulations vary significantly from state to state and you will need to comply with each state that you have employees resident in. California is one state in particular where careful attention must be paid to compliance.

2. Maintenance

Plan to monitor certain items on an ongoing basis.

• Stay current on your 409A valuation. Initiate a new 409A process if your valuation is more than 12 months old or if you’ve hit a significant milestone, whether it’s financial (such as a closing a financing), product, or sales-related. A 409A valuation allows you to determine the exercise price for stock options in order to meet IRS guidelines, which includes using a bona fide third-party 409A valuation company.
• Create your equity budget. Design a hiring plan for the period until your next funding event. Determine the total number of stock options that will be needed as compensation for new employees.
• Size the pool. With board and stockholder approval, create a stock option pool of the appropriate size.
• Track the pool. Monitor your stock option allocation over time. Is your pool still sufficient for future hires that you need to make? If not, you need to raise this issue with your board and re-plan.

3. Make offers

Consider this your checklist for making a prospective employee an option grant.

• Check your budget. Before making an offer to a candidate, confirm you have enough unallocated shares in the pool to cover the offer. This is a simple and very common mistake. "Uncovered" options are invalid and repairing this mistake later can impact the value of the employee’s grant and expose your startup to legal risks.
• Confirm employee details. Confirm the residency and work visa status of your prospective employee. Can they legally work for you?
• Check the grant size. Note that any new employee whose total ownership or equity represents more than 10% of the company must have a strike price that is 110% of the 409A price-per-share valuation, not 100% as usual.
• Deliver the grant. Provide an offer letter to the prospective employee including details of their stock option grant. The grant should be identified in terms of number of shares, not percentage of the company. The offer letter should clearly state that the grant amount and exercise price is subject to board approval.
• Rule 701 compliance: This rule provides an exemption from the registration requirement of the Securities Act of 1933 for the issuance of securities to employees by private issuers. To comply with this exemption your startup must issue stock within the constraints of rule 701. Rule 701 includes limits on the total value of stock options you can issue in one year. The total value being the total number of options issued × their respective exercise prices. In order to comply, this total value cannot be greater than the larger of 3 measures: (1) $1,000,000; (2) 15% of the total value of assets on the startup’s latest balance sheet; (3) 15% of the issued securities of the same class being offered (not counting securities issued under Rule 701). Here are some useful example calculations for the Rule 701 total value criteria above. If the total value of options issued is greater than $5M, you will need to provide specific information about your company to the new employee.

4. Finalize stock option grants

The dotting of the i’s and crossing of the t’s.

• If your current 409A is still valid (less than 12 months old or there has been another valuation event like a priced financing round), then no action is required. However if there has been a new 409A valuation since the last board meeting this needs to be reviewed and approved by the Board prior to or simultaneously with the approval of the employee’s stock option grant.
• At your next board meeting, you need to ensure that the board approves the employee’s stock option grant. If there are any material differences from your standard company offer e.g. vesting schedule, the recorded board approval needs to note these differences.
• The employee’s stock option agreement needs to be processed and executed.
• The company cap table needs to be updated with details of the new stock option grants.

"One of the most common mistakes I see is where companies have forgotten to give the final, executed stock option agreement to the employee. Fixing this simple error may require the board to re-approve the grant at a later date. If the option strike price has changed in the interim this can impact the employee’s proceeds in the event of an exit." — Frank Vargas, Partner at Rimon, P.C.

Make the time, you'll thank yourself later

Founders are busy. There are hardly enough waking hours in the week to work on your core mission, never mind spending time on administrative tasks. However, this stuff matters. Running your startup well can sway investors, help you hire great employees, and reduce the chance of missteps that can hurt or even kill your startup.

A significant theme in the four-step process outlined above is managing information correctly. Tracking against your hiring plan, tracking the number of remaining options in the option pool, keeping your 409A valuation up to date, knowing whether you are hitting any regulatory limits on total options issued, etc.

Founders can consider using an employee stock option management software to simplify and automate the stock option planning process. Leveraging software results in less risk of errors and mistakes, helping you maintain compliance with relevant regulations and laws.