A four-step plan for setting up and running your startup’s stock option process

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 process:

1. Setup

2. Maintenance

3. Making Offers

4. Finalizing Grants

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

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1. Setup

This section describes the 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 company 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 company do you plan to share with early employees? How do you want to reward people who join later? How standardized do you want your 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. You can get this paperwork done for as little as $200 using the service provided by Clerky.
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. See section IV. “Blue-sky issues” in this article from WilmerHale for more about individual state requirements.

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2. Maintenance

This section describes items you’ll need to monitor 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.

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3. Making offers

This section provides a 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: 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. Joe Wallin has an informative post on rule 701, including state exemptions.

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 the 3 measures below.

$1,000,000
15% of the total value of assets on the company’s latest balance sheet
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.

Also, 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. For details on the information required, see the section “Disclosure Rules” in this article by the National Center for Employee Ownership.

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4. Finalizing Grants

This section describes the dotting of the i’s and crossing of the t’s.

If your current 409A is still valid, i.e. is 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 grant.

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.

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In conclusion, it is crucial for startup founders to understand and take ownership of their company's stock option process. Getting it right from the beginning can save you from costly mistakes, legal issues, and employee dissatisfaction down the line. Remember, owning this process doesn't have to be complicated, and it's an essential part of building a great company.

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A four-step plan for setting up and running your startup’s stock option process

1. Setup

2. Maintenance

3. Making offers

4. Finalizing Grants

Further reading

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