The When and How of Issuing Stock Options to Employees

As an early-stage startup founder, you must be having a keen eye on the cash flow. Though you want to make hires who would possibly take your business vision up a notch, you might necessarily have the resources to match their cash expectations. What should you do in such situations? One-word answer – stock option grants! For many a year, founders have been leveraging stock options to attract, hire and retain the best talent.

Read this blog to understand the nuances of stock options. 

But you need to be careful. Stock options are an important asset and must be spent judiciously and in a very mindful manner. Remember the following while issuing stock options to your employees: 

Know the type of stock options

Two types of stock options can be issued to employees – Non-qualified Stock Options (NSOs) and Incentivized Stock Options (ISOs). NSOs and ISOs differ in terms of who they can be issued to, regulations & tax implications.

While NSOs can be granted to anybody, including employees and consultants, ISOs are reserved exclusively for employees. NSOs are taxed twice – at the time of exercise (as ordinary income) and again at the time of sale (as capital gains). On the other hand, ISOs are taxed only at the time of sale (as capital gains).  Also, ISOs can be transferred to nominees if the primary recipient dies, but NSOs are non-transferrable.NSOs are most favorable as companies can claim tax benefits when recipients exercise them. Also, they are easy to administer and manage.

Issuing Stock Options

For issuing stock options, you need to have a stock option scheme in place, and it should be in consensus with all the board members. The stock option scheme can be customized, and it can be drafted by law firms or attorneys. Ensure that this stock option scheme includes all the terms and conditions of the stock option deal, strike price, vesting schedule, conditions of engagement in specific situations, and any other information that the recipient should know. Stock options are considered securities and are subject to the Securities Law of the Securities and Exchange Commission (SEC). So, be very careful while drafting the stock option scheme.

Setting the strike price

Note that the strike price of stock options can be equal to or less than the Fair Market Value (FMV) of your company shares. The FMV can be figured out through an independent appraisal or 409A valuation.

Granting stock options

Stock options should be granted, keeping in mind the stage at which your startup is. Early-stage startups should be quite aggressive when it comes to stock option grants as the core team is to be formed, and you want to onboard the right set of people. On the other hand, growth-stage startups should be more conservative as the valuation will be higher, and stock options must only be leveraged to make senior hires who can help scale the business. There’s a downside to offering too much equity as well. The bigger the stock option pool, the more founders’ shares get diluted. A healthy stock option pool could be somewhere between 15% to 20% of total equity.

Determining the Vesting Schedule

In very simple and general terms, vesting refers to the amount of time an employee must work before acquiring the stock option benefit. Vesting is, therefore, the process by which an employee becomes eligible to exercise his/her stock options and become a shareholder in the company. Along similar lines, a vesting schedule is the time frame that establishes for how long employees must work for you before they can exercise all or a part of the stock options that are granted to them.

You must also account for the compulsory 1 year cliff period before actual vesting starts. The cliff period is put in place to ensure that employees work for at least one year from the date of the initial option grant before the vesting of their options starts. While vesting schedules can be tailored to get the stock option grants in line with the vision of your startup, you must know two types of vesting schedules:

• • Uniform Vesting: If an employee is granted 10,000 options with 25% of them vesting per year for four years, the employee will have the right to exercise those 25% options and have the right to buy 2,500 shares after one year from the vesting start date. The next 25% would vest two years from the vesting start date, and so on. If the employee decides not to exercise all 25% vested options after year one, there would be a cumulative increase in exercisable options. Thus, after year two, the employee would have 50% vested options.
  • Performance-based Vesting: In business verticals with high churn rates, a Performance-based Vesting plan can attract top talent as well as act as a sop to get the best out of employees. Since the vesting plan is tied to the performance of the employee or the performance of the company, i.e., the collective performance of individuals, it keeps employees on their toes to give their best to the company to achieve the conditional predetermined goals.

Termination of employees with stock option grants

If employees are terminated without cause, all of their stock option grants should ideally lapse and return to the option pool. However, you can allow such employees to exercise their vested stock options until a certain time frame after the termination date. All these clauses should be mentioned in the stock option scheme document.