Stock options are still the most common form of equity compensation used by private startup companies. In order to provide a quick reference tool, we put together the following checklist of the key requirements and best practices for granting stock options.1
- A stock option should be granted under a written stock plan that is approved by shareholders within 12 months of the date it is adopted by the company's board of directors.
- There are 2 types of stock options: incentive stock options (ISOs) and non-statutory stock options (NSOs). The difference between them is the tax treatment of the award. ISOs potentially result in a better tax situation for the individual, but several additional requirements apply in order to get the tax benefits. An option is not an ISO if its terms at grant provide that the option will not be treated as an ISO.
- The stock plan should include the maximum aggregate number of shares (a) that can be issued through the exercise of all stock options and (b) that can be used solely to grant ISOs.
- The terms of a stock option must state that the option is not exercisable after 10 years from the date the option was granted (or, with respect to ISOs, after 5 years from the date the option was granted to an employee who owns 10 percent of the company's stock).
- A stock plan should have a term of no more than 10 years from the earlier of date the stock plan is adopted or approved by shareholders.
- The stock plan should provide that options cannot be transferred, other than by will or the laws of descent and distribution or certain limited family transfers in the case of NSOs, and should provide that ISOs are exercisable only by the employee during the employee's lifetime.
- Due to tax rules, stock options should be granted for common stock and not preferred stock.
- Securities laws may require that when certain corporate events occur (like spinoffs, stock splits, or reorganizations), stock options must be adjusted to prevent enlargement or loss in value to the option holders, and the terms of adjustment must be set forth in the stock plan.
- In California, option holders generally must be permitted to exercise their stock options following their termination of service (unless terminated for cause) for at least 6 months from the date of termination if the termination is due to death or disability, or for at least 30 days in the event of other terminations.
- A stock option typically must be granted after the individual's service with the company has started.
- Options under the stock plan generally can only be granted to service providers of the company and its majority owned subsidiary companies.
- ISOs can only be granted to employees. NSOs can be granted to employees, directors, consultants, independent contractors, advisors and other non-employee personal service providers.
- In general, it is not advisable to grant options to service providers of a parent company unless the individual also performs bona services for the subsidiary granting the options.
- The exercise price of a stock option should not be less than (a) 100 percent fair market value (FMV) of the underlying shares on the grant date, or (b) with respect to ISOs, 110 percent of the FMV of the underlying shares on the grant date for employees who are 10 pecent shareholders.
- The total grant date FMV of ISOs that can become exercisable for the first time in any calendar year cannot exceed $100,000. If any ISO in excess of the $100,000 limit become exercisable for the first time during any calendar year, the excess is treated as an NSO.
- The startup should confirm that it is compliant with an applicable federal securities registration exemption (generally Rule 701) and a state securities registration or qualification exemption (generally, Corporations Code section 25102(o) in California) when it grants a stock option.
- The board of directors typically approve stock option grants by means of a unanimous written consent or resolutions adopted at a meeting that complies with company bylaws, its charter and applicable corporate law. In addition, the board approval must include the material terms of the grant, including the exercise price per share, a fixed number of shares, and the individual’s vesting schedule.
- The startup must give each option holder a copy of the stock plan and stock option agreement within a reasonable prompt period of time after the grant of a stock option.
- ISOs may only be exercised within 3 months of termination of employment and, in the case of disability, no later than 12 months after termination of employment. Exercise beyond these periods, even if permitted by the option agreement, will result in the exercise receiving NSO treatment.
- The stock plan should have terms and conditions regarding the treatment of stock options upon the occurrence of a change of control or similar corporate transaction. These contractual terms should be carefully thought out by the startup when the stock plan is adopted. However, variations of this treatment may be provided in individual option agreements.
- In determining the FMV of the underlying shares subject to a stock option, the startup should consider obtaining a third-party valuation of its common stock at least every 12 months (or earlier, if material corporate or market events have occurred).
- The startup should maintain and update a capitalization table each time a stock option grant is made. The table should list the option holder's name and address, the award's grant date, exercise price, type of option (NSO or ISO), expiration date, vesting schedule, location at time of grant and the securities registration relied upon for the grant, and whether the option may be exercised for restricted shares prior to vesting (so-called early exercise options.
- Before stock options are exercised, the startup should confirm that it has the proper payroll processes in place to (a) report and, if applicable, withhold taxes on wage income resulting from stock option exercises and (b) with respect to ISOs, file annual notices pursuant to IRS rules.
- It is not typical to delegate authority to grant stock options to officers (or management-level employees) and it is usually is not advisable to do so unless strong corporate governance processes are implemented.
- Option holders should be required to sign their option agreements and promptly return a copy to the company.
Stock option awards are a frequently used tool to incentivize service providers. However, since options do involve some complexity, seeking strong corporate legal counsel is advised to ensure that mistakes (especially in regards to tax and securities law compliance) do not occur. Keep in mind that stock options are typically used to attract, motivate and retain service providers and compliance errors in compensating your personnel likely would undermine these goals.