When it comes to startups companies, especially private, venture-capital backed companies, grants of Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs), known colloquially as “options”, are considered the “coin of the realm” – they are often viewed as a path to overnight wealth, and in the startup community employees and consultants typically expect to receive option grants when hired.
Obviously not all companies end up being successful, and as a result not all options result in life-changing wealth. Moreover, while many people have heard of options and know to ask for them, many of those same people don’t understand what options actually are, or how they work. While the option approval and issuance process is generally straightforward, there are some details that founders, CEOs, CFOs, heads of HRs, and others who are involved in the issuance process should be aware of when granting options.
- What are “options”?
At its most simple, fundamental level, an “option” is a right (but not an obligation) to do something (such as the right to purchase something). “Options” as referred to and granted by companies to employees and contractors is short-hand for “stock options”, which is a type of contract or agreement in which the holder of the stock option has a right to purchase stock of the company issuing the option.
Stock options typically grant a right to purchase a set number of shares of common stock of a company, at a certain price, during a certain time period, and typically subject to vesting, further details of which we’ll address in this and other blog posts.
For the purposes of this blog post, our use of “options” is synonymous with “stock options”.
- What is the difference between “options” and “shares”?
Options are NOT the same as stock or shares in a company. The holder of an option has the right (but not obligation) to purchase shares of stock of the company, but does not actually hold such shares of stock unless he/she actually purchases such stock (such purchase, in the context of an option, is referred to as the “exercise” of an option).
Prior to the exercise of an option, the optionholder does not hold stock, and therefore does not have the same rights as a stockholder, namely the right(s) to:
– vote shares in matters of the company requiring shareholder approval (such as voting for a director or voting on the sale of the company);
– receive dividends issued to shareholders if declared by the company; and
– receive a portion of the proceeds/distributions issued to shareholders in a sale or liquidation of the company.
So if stockholders have rights that optionholders do not, why don’t companies simply grant shares of stock? Primarily for tax reasons. The receipt of an option, if done correctly, does not result in taxable income to the recipient, whereas the grant of stock outright could result in taxable income, unless the recipient actually pays fair value for the shares received, which for later stage companies (where the share price is high) could be very costly.
- What is an ISO and an NSO, what is the difference, and why should I care?
In the United States, the Internal Revenue Service (IRS) – the US taxing authority — recognizes two types of stock options: Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs). Both of these types of options are defined by the IRS tax code, with the difference being the tax treatment that each type of option has.
ISOs in some cases have more favorable tax treatment than NSOs. That more favorable tax treatment includes no tax upon exercise of an ISO (except in cases where AMT applies), whereas there may be taxable income upon exercise of an NSO.
However, in exchange for the (slightly) more favorable tax treatment, the IRS places more restrictions on ISOs versus NSOs, including:
– placing limits on who can be granted an ISO (ISOs can only be granted to employees, whereas NSOs may be granted to employees as well as to contractors/advisors);
– placing a hard cap on the value of ISOs that may be granted/exerciseable in a given calendar year (only $100K worth of ISOs exerciseable in a given calendar year may be granted to an individual, whereas not such limit exists for NSOs); and
– an additional holding period (to qualify for long term capital gains treatment, stock exercised from an ISO must be held for a period of two years from grant and one year from exercise, whereas the hold period for NSOs is only one year from exercise, regardless of grant date).
Where the holder of an ISO does not fulfill the IRS requirement to be eligible for ISO treatment, such option simply defaults to NSO treatment. As a result, most companies typically try to grant their employees ISOs (and grant NSOs to consultants and advisors). If there are questions regarding what type of option to grant to an employee or service provider, we suggest you consult your attorney.
In addition, as ISOs and NSOs are a function of the US tax code, the distinctions between these two types of options may not be relevant for those who are subject to tax outside of the United States; for employees or consultants outside of the US, such employees or consultants should consult their own tax advisors regarding how such options may be treated and taxed under their own tax regime.
- What is an equity plan?
An equity plan typically comprises of plan document(s) approved by the Company’s stockholders and Board, that provide for certain terms and conditions that govern how equity grants are issued and approved, as well as govern things such as how and when equity may be transferred, what happens if the holder leaves the company or dies, how and when a company may repurchase unvested equity, etc.
The plan document(s) typically comprise of both the plan itself, and various additional documents, such as a form of option agreement, form of option notice, form of exercise notice, etc. that contain various terms and conditions relating to equity grants. Equity plans are typically set up to include specific provisions to ensure that the plan is compliant both with IRS regulations relating to the issuance of ISOs and NSOs (to ensure the grant of such options comply with the various ISO and NSO requirements), as well as additional provisions to ensure that the equity plan complies with the US Securities Exchange Commission (SEC) rule 701 Exemption, allowing the issuance of securities under a compensatory plan without the need for separate reporting or filings with the SEC.
Given that equity plans must comply with both SEC and IRS regulations, companies should always source their plan documents from a reputable law firm. The plan (including the relevant documents) must be approved by the Company’s Board and Stockholders before it is effective; companies should have a plan approved BEFORE it approves the issuance of any options.
- What is an equity pool? How many shares should I put into an equity pool?
As noted above, companies must approve an equity plan before it issues any options. In addition to approving the plan and plan documents, companies also must approve a certain number of shares that may be issued under the plan, typically done at the same time that the plan is approved (and later if/when the shares under the plan must be increased).
Shares approved to be issued under the company’s equity plan are almost always common stock of the company; preferred stock is typically reserved for issuance to investors of the company.
Shares approved to be issued under the company’s equity plan are often referred to as the “equity pool”, “pool” or “ESOP” (acronym for Employee Stock Option Plan/Pool). The reason for the pool is to ensure enough equity is set aside to grant options to various current and future employees, in anticipation of the company growing and needing to issue options to attract talent. Shares for the pool are typically set aside at the time of the approval of the plan, and are often increased (referred to as “reloading” the pool or ESOP) at the time of a financing.
As a general rule, most outside venture capital investors and other institutional investors ask that companies set aside roughly 10% of their fully diluted capital (10% of total stock of the company that is either already issued to founders, investors or employees, or that is issuable under the pool) to be available post closing of a financing. Note that while the 10% is a rough rule of thumb, the actual percentage is generally negotiable.
- Who needs to approve an option grant?
Equity plans of venture backed companies are typically structured such that, as part of the approval of the plan by the stockholders of the company, the stockholders further empower the Board of the company to approve any grants of equity, including any amendments or changes to any equity grants (such as changes to vesting, exercise price, etc.). This is often reinforced by investor financing documents, such as Investor’s Rights Agreements, which further provide for both guidelines on the type of option grants and vesting terms that companies may approve, as requirements for Board approval (including in some cases approval of the Preferred Director) of option grants.
Therefore in almost all cases the company’s Board must approve any and all option grants. In some instances, where a company is at a very early stage and a founder is both the CEO and sole Board member, some founders run into issues where they do not formally document the approval of option or other equity grants via board consents or minutes. This often becomes an issue later, during a financing, where investor counsel reviews the company’s corporate records and discovers that certain equity holder or option holders on a cap table do not have the requisite approvals in place.
As noted earlier, in the US, options have specific tax treatment, and as a result, also have specific requirements in terms of determining the exercise price based on the fair market value at the time (date) of approval of the grant. Understanding the specific dates of when an option was approved, and what the relevant terms were at the time of approval, are crucial to whether an option is actually “approved” and how it will be treated from a tax perspective. These issue, if they arise, can have enormous negative economic and tax consequences to the putative option holder if not documented correctly, and so we always advise companies and founders to keep their outside counsel in the loop when approving option grants.
- Who can options be granted to?
Options can be granted to any service providers of the company, including employees, consultants, directors and advisors.
However, under that relatively broad umbrella, companies granting options should be aware of a few things:
- Options granted out of a typical equity plan can only be granted to bonafide service providers who are natural persons pursuant to SEC rule 701, ie., they can only be issued to individuals who are employees, consultants, board members or advisors of the company, and not to entities such as corporations, partnerships and trusts (note – post exercise, the shares underlying the options may be transferable to such entities, subject to any approval rights and restrictions contained in the company’s bylaws and investor documents);
- The service provider must be providing services (eg employed or under contract) at the time the Board approves the grant; the Board cannot approve an option before the date the recipient starts providing services;
- While options may be granted to non-US employees or consultants, as noted previously, the tax treatment of such equity grants may differ from jurisdiction to jurisdiction, so the company may want to discuss such grant with non-US recipients (including having such non-US recipient talk to their own tax counsel) to ensure that there are no adverse tax consequences if/when the recipient receives the option;
- Where options may not be granted (eg entities), some companies instead grant warrants, which can be structured similarly to an option (although they may not have the same tax treatment to the recipient). Note, shares underlying a warrant are typically outside of the “pool” and therefore the company must be sure that enough authorized and unissued shares exist to allow for such warrant grant.
In addition, as may be clear from above, companies typically do not grant options to investors (those seeking to purchase equity from the company for investment purchases), as the purpose of the equity pool is to allow for the grant of equity to incentivize service providers, and moreover, investors typically prefer to purchase preferred stock of the company.
- What information do I need to grant an option?
As noted above, the company’s Board must approve options, and such approval must include certain required information such as:
- the date of the approval
- the fair market value/409A at the time of the approval (and that a valid 409A valuation is in effect as of the date of the approval)
- the exercise price;
- who the recipient is;
- the type of option being granted (ISO vs NSO);
- the number of shares under the option being approved;
- the vesting terms (including the vesting commencement date, period of vesting, vesting cliffs, acceleration, etc.)
- the total number of options/shares being approved (and whether there are enough shares under the available pool to cover such approval)
For companies using platforms such as Carta and Pulley, such platforms often provide templates and/or tools that allow companies to generate a Board consent approving options, and will solicit the necessary information.
However, please note that Carta/Pulley may not address questions about how/when to vary vesting terms, when to allow for acceleration, whether terms conform with requirements under the company’s financing documents, and/or whether other special approvals are needed where the terms may not conform with such investor requirements. In addition, as mentioned, options out of a plan typically cannot be granted to non-natural persons and to service providers who are not yet providing services.
We believe in a measure twice, cut once approach to equity grants and approvals, and where appropriate, often review offer letter/contractor agreements to ensure the Board approvals match the underlying documents. Therefore, we think it is still best practice for companies to consult with their legal counsel when preparing and approving option grants, even when using platforms such as Carta or Pulley.
- Is including option language in an offer letter the same as approving an option?
No. As noted above, in almost all cases the Board of the company must formally approve an option grant, and such approval must include certain required information such as the date of the approval, the fair market value/409A at the time of the approval, the number of shares approved, the vesting terms, etc.
Language in an offer letter, although a contractual promise by the company to the employee regarding a potential future grant, is not in and of itself approval of an option grant. Moreover, for that reasons, with respect to the drafting of offer letters to employees, we always advise that any language regarding the grant of equity always be drafted in such a way as to make clear that the grant will occur “subject to Board approval”, and further that the exercise price of the grant will always be subject to the fair market value at the time of such grant.
While founders and companies are often well-meaning and intend to try to get option grants approved soon after an employee accepts an offer, it is often difficult from a process standpoint for a company to convene its Board or send out a Board consent to approve an option after each and very employee hire. In most cases it is much more efficient to batch approvals for multiple grants into a single consent once a quarter.
One additional thing to note – between the time an employee is hired and/or promised an option, and the time that the Board actually approves such option grant, the fair market value of the company’s stock may change (eg the company receives a term sheet or starts a financing round), which would change the fair market value/strike price that was prevailing at the time the offer was sent, as well as prevent the actual approval of the option grant (as typically options cannot be approved until there is a valid 409A value, which typically can’t be determined until AFTER a priced round financing has closed). In such cases we recommend conferring with outside legal counsel regarding whether grants may be made and what the relevant 409A value may be at the time of the Board approval.
- If an option is entered it into Carta/Pulley, that’s all I need, right?
No. As noted above, in almost all cases the Board of the company must formally approve an option grant. While platforms such as Carta or Pulley may solicit all of the necessary information needed to approve an option grant, the input of such information into the platform in and of itself is not the same as an approval. The company’s Board must still formally approve the options.
As noted above, in both the case of Pulley and Carta, such platforms do provide certain tools to allow for the approval by the Board – however, the company must still ensure that the relevant consent is actually signed and approved by the Board (including the date of such Board approval, which is typically the date when ALL signatures needed from the Board have been received, not necessarily the date the consent was sent out for signature).
Also, please note that Carta/Pulley may not address questions about whether certain vesting terms make sense for certain recipients, whether proposed terms conform with requirements under the company’s financing documents, and/or whether other special approvals are needed where the terms may not conform with such investor requirements.
Ultimately, platforms such as Carta and Pulley are wonderful, user friendly, and an important tool for companies to track and maintain their cap tables, but they are still ultimately databases and bookkeeping/record keeping devices. Actual approvals must occur at the Board level, so we always believe that best practice for a company is to continue to involve their legal counsel in the equity approvals process.
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