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Avoid these common pitfalls when granting stock options

Taking stock of your stock options

Stock options are a standard feature in nearly every startup and early-stage company. They’re a fantastic tool for recruiting and employee retention while aligning the interests of employees and the company.

However, when it comes to granting options, there are simple mistakes companies can make which could haunt them for years to come, potentially impacting their next deal or financing round—and dis-incentivizing the very employees they were looking to help.

1. Failure to get board approval

Let’s start with an obvious one that founders routinely miss in the early days: Stock option grants must be approved by the board.

If the board doesn’t approve (either at a board meeting or by unanimous written consent), the stock options haven’t actually been granted. When the company later tries to fix this oversight—usually after the value of the company has gone up—they are forced to grant the options with a higher, current value exercise price as opposed to the lower price that the employee was supposed to receive.

It’s never good to tell employees they aren’t going to share in the increased value of the company they helped build simply because you failed to follow corporate formalities. Luckily, this problem can easily be avoided simply by having a standard board consent that you use each time options are granted. Your board members can even approve via email

2. Not granting at fair market value

Don’t forget that option grants must be made with an exercise price at fair market value as of the grant date (usually the date the board approves). If the grants are not at fair market value, IRS rules not only tax the option at the time it vests, it also imposes a 20 percent penalty tax on the income. Additionally, some states—most notably California—impose additional penalty tax.

However, determining the fair market value of common stock at an early stage of a private company can be a difficult task precisely because the shares aren’t publicly traded. Beware of using the valuation implied by your last fundraising round as a proxy for fair market value. Because many financings consist of convertible notes or preferred classes of stock, the fundraise valuation may not actually reflect the fair market value of the common stock granted under employee option plans.

While somewhat costly for an early-stage company, the best way to proceed is to retain an outside firm to determine the fair market value by conducting a valuation in compliance with Section 409A of the Internal Revenue Code (referred to as a “409A valuation”). The advantage of this report is that it shifts the burden to the IRS to demonstrate that the option price was not at fair market value if it is ever challenged. Without this report, the company bears the burden of proving that the option price represented fair market value, usually at a time when the IRS has the benefit of hindsight.

3. Failing to renew the valuation report

Having obtained your 409A valuation, don’t forget that the report isn’t good forever. Under IRS rules, you must obtain a new 409A valuation at least every 12 months. Additionally, if the company experiences a “material change”—such as receipt of a term sheet for a term sheet for a new financing round, an acquisition or a divestiture—you will need to renew your 409A valuation. This means that, if the company is contemplating an imminent fundraise or major transaction, you may need to stop granting stock options until after the transaction closes—and you can obtain a new valuation report which takes into account the changed circumstances. Again, failure to comply with Section 409A exposes your employees to potentially severe tax consequences.

Alastair Wood Kindur Fair Market Value

4. Failure to follow securities law

Many fledgling businesses forget that federal securities law actually prohibits selling securities to the public without first registering the offering with the SEC. Fortunately, Rule 701 provides an exemption from registration for private companies offering stock options under an employee stock option plan, subject to certain strict mathematical limits that cannot be exceeded.

Specifically, during any consecutive 12 month period, the total sales price or number of shares sold under Rule 701 cannot exceed the largest of (i) $1 million; (ii) 15 percent of the issuer’s total assets; (iii) 15 percent of the outstanding securities in the class. In addition, special disclosure requirements are triggered if the total sale price of the shares sold in reliance on Rule 701 exceeds $10 million in a 12-month period.

Google famously tripped into Rule 701 violations by issuing options in excess of these limits in the years prior to its IPO. This mistake resulted in a public cease and desist order from the SEC against both Google and its general counsel a year after the IPO (clearly not an ideal outcome for a newly public company).

Additionally, don’t forget that local securities law may also apply. Some states, like California, require filings and the payment of fees to grant options to residents of that state. Similarly, when making equity grants outside of the United States, companies must ensure compliance with non-U.S. securities law.

5. Stock options are only for people

Finally, Rule 701 generally provides that only natural persons can be granted options under a stock option plan. This issue often arises when a consultant provides services to the company and asks to have their options titled in the name of their LLC.

While it’s usually fine to grant stock options to an individual consultant under the option plan, grants generally can’t be made to an entity. If you want to grant options to non-individuals, consult your attorney. You may have to grant them outside of your stock option plan, which requires a separate exemption for registration requirements.

Misunderstanding the rules around option grants can occur early in a company’s life, often before the company has dedicated counsel to help with these issues. However, by being aware of potential missteps in advance, you can avoid potentially costly mistakes which can impact your company and your employees down the road.

 


Alastair Wood is the General Counsel at Kindur, an innovative FinTech and InsurTech platform offering digital wealth management, financial planning, asset management and insurance services to baby boomers approaching and in retirement. Prior to joining Kindur, Alastair served as chief of staff to Citigroup’s General Counsel and Chief Administrative Officer for Citi’s 1,500+ global legal team.

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