Best Practices for Issuing Stock Options to Startup Employees

Here is a quick list a company can refer to prior to issuing stock options to its employees.  I’ve covered the basics of stock options in a previous post, as well as a more in depth pricing item related to stock options, but wanted this post to give the broad overview to founders.

  1. Have a Two-Fold Plan

First determine what employees or contractors you want to motivate with options, and how many you want to issue to such individuals, while forecasting how many more you may need in the near future.

Second, the corporation will need an actual written plan. This can be a Stock Option Plan that allows for only issuance of Incentive or Non-Incentive Stock Options, or a broader Equity Incentive Plan which allows for issuance of both types of options, restricted stock, phantom stock and stock appreciation rights.  Whatever it is, get it in writing.

  1. Have both the Board and the Shareholders approve the Plan

Either  at a meeting or via written consent, make sure you have both the board and shareholders (check state laws, but DE requires shareholder approval) approval of the written plan.

  1. Reserve and account for the stated amount of Shares that the Plan Covers

This is usually a note or section of the startup’s cap table.  The Plan should set forth (i.e. reserve) a certain number of shares which can be issued pursuant to the plan.  So for any issuance under the Plan, the Board (or Committee) administering the Plan doesn’t have to get approval for any future issuance under the Plan.

Make sure the reserved stock is available in the treasury shares (aka authorized shares) of the corporation based on its current certificate of incorporation. If the corporation’s certificate of incorporation is amended in the future, I like to put in the existence of the Plan and how many shares are reserved under same.  Then when issuing any stock in the future, you may have to amend the certificate to increase the amount of authorized shares, treat the pool as if it was issued.

  1. Use Sufficient Agreements and Grant Notices

When it comes time to start granting awards, it should be done using a customized agreement and grant notice.  Usually, but not always, the Board will have a form agreement it will base any grant off of.  The Plan should allow the Board to customize any such agreement.  These documents should cover things like vesting and other considerations. One you find online may or may not have the proper items, but either way you’ll likely need an attorney’s help to customize it to any employee.

  1. Set the Fair Market Value Exercise Price of the Option

This should be done regardless of whether the option is an Incentive or Non-Incentive Option.  The best way to do this is to have a company perform a 409A Valuation.  While this entails a cost, it is less than it has historically been and it absolves the corporation of some potential liability.

There is also the ability for an individual to perform an Illiquid Startup Appraisal, which is available in some circumstances, can be performed by an insider, and would be less costly than a 409A Valuation. D&O Insurance is a good idea if options are to be issued without a 409A Valuation.

  1. Abide by Securities Laws

On the federal level, Rule 701 allows for issuances pursuant to written compensatory plans, provided you stay under certain limits each year.  The State Blue Sky Securities laws are an often overlooked step.  Most states have exemptions similar to the federal rule but not all of them.  Make sure to check the state law where each optionee resides, you may be surprised at how out of touch with reality some states are with respect to these kinds of things.