At some point early in the life of a startup, the founders talk about issuing options to employees and potentially others who provide services to the company. Usually, until that point, the founders have allocated the company’s shares among themselves under a founders agreement or similar arrangement.
What are Stock Options?
The right of the recipient of the option to buy common stock of the company at the “exercise price” (the fair market value of the common stock when the option is issued) at a future date after the option has “vested.” Therefore, if the value of the company’s common stock increases after the option is granted, the recipient will benefit from the difference in the stock price between the date of issuance of the option and the date of exercise of the option.
Why do Companies Issue Stock Options?
- Stock options provide an incentive to employees when startups cannot afford to pay them market salaries
- They attract talented employees
- They can used to reward high-performing employees
What is Needed to Issue Stock Options?
- A written stock plan approved by the shareholders and the board
- The stock plan will provide for two types of stock options:
- ISOs – Incentive Stock Options – issued to employees, which have certain tax benefits
- NSOs – Non-statutory Stock Options – usually issued to directors, consultants, and service providers
- The exercise price of the stock option should not be less than fair market value of the company’s stock at the time of grant of the stock option (110% of fair market value for 10% shareholders)
- Vesting requirements should be specified, (e.g. 1-year cliff, then vesting 1/36th monthly)
- Securities laws should be met since the option is a security. The federal exemption from registration applicable to options is Rule 701, and in California the state exemption is California Corporations Code Section 25102(o)
- There are various financial tests that need to be met when options are issued to comply with tax and securities laws
Do Options Really Provide an Economic Incentive and Benefit to Employees?
Sometimes. While millionaires have been created in Silicon Valley through stock options and they are a compelling recruitment incentive, sometimes employees do not benefit from the stock options.
- The stock options are illiquid (there is no active trading in the stock options or the underlying shares), and employees may not be prepared to invest in a risky, illiquid stock
- Employees are typically required to exercise their stock options within 30 to 90 days after leaving the company. Because this usually requires the exercise price to be paid in cash, even if the options are “in the money” employees may not elect to exercise. Companies are beginning to think of ways to make their option plans more employee-friendly so that employees can share in the wealth of the company they have helped to build.
If you require any further information about stock options or setting up a stock option plan, please contact Edward Grenville, Managing Shareholder, Inspire Business Law Group, PC (email@example.com; +415 279 0779; www.inspirelawgroup.com).
This article is provided for educational and informational purposes only and is not intended to be, and should not be construed as, legal advice.
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