The popularity of stock options is at its height in the private market ecosystem today. While founders leverage stock options as a tool to attract, retain and reward the best talent, employees think of stock options as a non-linear compensation for the risks they take by joining startups. Yes, the advantages of stock options are many.
However, mistakes while granting stock options can cause serious financial, tax, and regulatory hardships, and also result in disputes between employers and employees. As with most things in business, doing things right the first time leads to building more and fixing less in the long run.
6 Mistakes to Avoid While Granting Stock Options
Here are the most common mistakes that founders make around stock option plans
1. Failing to get board approval in the early stages
Before granting stock options, founders need to get a unanimous written agreement ready. Based on the clauses described in this agreement stock options are granted. If the board doesn’t approve, stock options cannot be actually granted. At a later stage, when the valuation of the company has gone up, granting stock options might not be of many benefits to employees. In such instances, stock options would be granted at a higher exercise price (based on the Fair Market Value), and this will significantly reduce the profit that employees would receive after selling their options. And, in almost all cases, would be quite unfair to employees.
2. Not delivering formal grant documentation:
Generally, offer letters do not have a mention of various stock option clauses including vesting schedule or exercise period. These details are presented in the grant documentation. By failing to actually deliver the grant documentation to the employee, the employer opens up to a lot of legal hassle around equity-related claims by employees, including what happens at the time of M&As, vesting schedule of stock options, and expectations around expiration or termination of the option grant. Employees might argue that related stock option-related provisions are not enforceable, leading to litigation when the stakes are high.
3. Granting options without doing a 409A valuation:
Stock options need to be issued with an exercise price equal to or greater than the fair market value of the equity on the grant date, to comply with IRS (Internal Revenue Service) rules. The IRS does not accept any equity value the company decides on. It has special requirements, including safe harbors, for setting the exercise price. This is why 409A valuations are done. To avoid conflicts with the IRS, it is advised that companies do a 409A valuation and determine the FMV of shares before issuing stock options. Also, companies should also remember that 409A valuations don’t hold good forever. 409A valuations need to be done every 12 months or before each new funding round, or before M&As.
4. Promising options in an LLC:
LLCs do not issue stock option grants but rather ‘unit options’. There are big differences between company a stock option and an LLC unit option. Creating a stock option plan for an LLC is far more complicated than for a corporation. Founders of startups formed as LLCs should not make promises of stock options before consulting with a competent tax counsel.
5. Inadvertently converting ISOs to NSOs:
ISOs and NSOs have different tax implications. ISO tax treatment is more favorable for employees as they pay no income tax upon exercise. On the other hand, NSO holders pay ordinary income tax on the exercise of any option to the extent FMV exceeds the exercise price. In general, ISOs must be exercised within 90 days of the last working date. However, the board can make a unanimous decision to extend the PTE (Post Termination Exercise) date for employees. In this case, the ISOs convert to NSOs. Employees who might be unaware of this conversion will become liable to pay the extra taxes that are pertinent to the NSO exercise.
6. Granting options that exceed the option pool:
Each stock option must be issued from a board-approved reserved pool of shares. It should be noted that in no circumstance the number of option grants exceeds the pool of reserved shares. Also, this pool of reserved shares must never exceed the number of authorized and unissued shares under the company’s certificate of incorporation. If grants exceed the reserved pool, they will be deemed invalid.