Five Things You Should Know About Stock Options

Startups often use stock options to attract, retain, and motivate talented employees. Stock options are complicated, however, so here are five key things any startup founder (and startup employee) should know about stock options, as well as two freebie tips.    

What Kind of Option Is It?

There are two kinds of options: incentive stock options (ISO’s) and non-qualified stock options (NSO’s). ISO’s can only be issued to employees of the company. NSO’s, on the other hand, can be issued to non-employees, such as directors, advisors, and consultants. The tax treatment of ISO’s and NSO’s is quite different.

If you have an NSO, you recognize ordinary income when you exercise the option, regardless of whether you sell the underlying stock at the time of exercising the option. Consequently, you may have a tax bill but no cash to pay it. If you have an ISO, you don’t recognize taxable income until you sell the underlying stock, and you get capital gains treatment if the shares acquired through exercising the options are held for more than one year after the exercise date, and are not sold prior to the two-year anniversary of the option grant date (among other conditions). This makes ISO’s much more favorable than NSO’s.

Better Price the Option at Fair Market Value

Under Section 409A of the tax code, the exercise price of the options must be equal to the fair market value (FMV) of the underlying stock as of the option grant date. Otherwise, the option grant will be treated as deferred compensation, with adverse tax consequences for the employee, and withholding obligations for the employer.

The Securities Laws Apply to Options

Stock options are securities, and therefore federal and state securities laws apply. Under the securities laws, a company cannot offer or sell securities unless (a) the securities are registered with the SEC, or (b) there is an exemption from registration. Fortunately, there is an exemption for offers or sales of securities pursuant to the terms of a compensatory benefit plan or written compensation agreement. Most states have a corresponding exemption. So, you need a stock option plan to take advantage of that exemption. This leads us to…

Do the Paperwork

The paperwork associated with a proper stock option plan is well-defined and complex, and it will cost money. This is when you really need to consult an experienced attorney, rather than trying to do things yourself at one of those legal document websites. You will need a stock option plan (and plan summary), a stock option agreement, stockholder resolutions approving the stock option plan, board of directors resolutions approving the stock option plan, and board of directors resolutions approving each option grant. Expect this to cost at least $1500.

Don’t Forget the Option Pool

The company will need to reserve a pool of stock for the option plan. While the pool should be big enough so that you can grant meaningful options to employees (and remember, your headcount will grow over time), you want to minimize dilution. A good size for your option pool is 10-15% of the total amount of authorized shares.

As promised, here are a couple extra tips:

Include Vesting

Make sure the options are subject to vesting. A typical vesting schedule is 4 years with a 1-year cliff. That means that the first 25% of the options will vest at the end of the first year, and the remainder will vest on a monthly basis over the next three years. You want to keep employees motivated, and if their options are fully vested from the outset, they won’t have an interest in sticking around.

Consider Using Restricted Stock Instead of Options

For earlier stage startups with few employees, it may be easier and less expensive to issue restricted stock, rather than stock options. There are several advantages. First, restricted stock is not subject to the fair market value rule of Section 409A. Second, because the recipients are getting actual stock, rather than options, the motivation may be somewhat stronger. Third, with restricted stock, the capital gains treatment and holding period begin at the date of the stock grant, provided the recipient files his 83(b) election on time. Fourth, you can use restricted stock with directors, advisors, and consultants, so you don’t have to worry about the ISO-NSO distinction. You’ll still need a restricted stock purchase agreement and some other paperwork, but the cost should be less than what is involved with a stock option plan. Just as with stock options, it is a good idea to have the restricted stock vest over time – 4 years for employees, and 2 years for directors and advisors.

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