Many companies, especially startups, run into pitfalls when issuing employee stock options. The most common problems occur in the following areas:
- Promising vs. issuing employee stock options
- Setting a vesting schedule as a startup
- Setting an employee stock option strike price
This article offers practical advice on how you can avoid issues in these areas for your own company. Let’s dig in.
Promising vs. Issuing Employee Stock Options
Companies can offer many different types of employee stock options. However, understanding the difference between promised and issued stock options can be tricky.
What Are Promised Stock Options?
Promised stock options, otherwise referred to as allocated stock options, occur when an oral or written promise is made in an employment letter to issue a certain number of shares as options to an employee. These options can be thought about as “potential” options as, at this stage, the employee has no ability to actually execute these options. In general, this promise works just like any other.
For example, remember that time you promised to have coffee with someone only to forget the meeting entirely and end up being a no-show? Promised stock options work the same way, and if you’re not careful, these options can be forgotten, causing big problems down the road for your employees. Not good!
What Are Issued Stock Options?
Issued stock options, otherwise referred to as granted stock options, occur when the company has given the employee a right to purchase a certain number of shares at a predetermined strike price via a legally-binding option agreement (more on stock option strike prices below). Issued stock options are real and can be executed by the employee per the terms of the agreement.
In general, you should issue employee stock options as soon as you can after promising them to avoid issues and minimize the backlash from a forgotten or unfulfilled promise.
What Is a Stock Option Strike Price?
The term strike price refers to the price your employee will pay for each share when it comes time for them to execute their options. This price should be set at the time the options are issued by consulting a valuation specialist to establish a fair market value for your company at the time of issuance.
Pitfalls to Avoid
There are two key problems to avoid when it comes to promising and issuing employee stock options. Let’s turn our attention to those and discuss how you can avoid them.
#1 – Upcoming Funding Event Causes Stock Option Strike Price Hike
A big issue is when promised options get forgotten until a new round of financing is closing, causing the eventual strike price for the employee to jump significantly.
You hire a new employee, Suzy, just after your seed round and you promise her 10,000 shares as stock options. Suzy is psyched, and she is the perfect hire for your marketing department. However, Suzy doesn’t have much option experience, and thinks the options are set in stone. Twelve months, and plenty of stressful situations later, you have forgotten about your promise to Suzy and you’re closing in on your Series A funding round, with a term sheet from a great lead investor! As a component of diligence, your lead investor asks who you’ve issued options to and all of a sudden you remember your promise to Suzy.
Now, it’s important to remember that promised stock options have no formal agreement in place regarding their execution and strike price, only a promise is made. You want to do right by Suzy, so you have your legal team draft an option agreement, and you prepare to present it to Suzy, but you realize you must pick a strike price. Your strike price must be at or above fair market value, and you just received a term sheet stating a market value for your company. You’re in trouble.
Suzy is going to get her options at a significantly higher strike price, costing her a lot more money to execute her options and significantly reducing the value of those options to her. This is not only not fair to Suzy, but it is going to come as a shock to her and cause significant disdain, lowering her loyalty to the company and damaging her relationship with you.
Solution – If You Promise Employee Stock Options, Issue Them Right Away
To avoid this situation, you should have a standard option agreement in place upon hiring new employees, and you should issue options immediately upon promising them. To issue them, you must take the following steps:
- Your board must resolve to establish an option pool.
- Your board must resolve to grant the shares you want to issue from the pool.
- You must engage a valuation specialist to establish a fair market value for your company to set your strike price (more on this in “How to Set a Strike Price” below).
- Your board must resolve to then issue the options at the strike price determined with reliance on the external valuation.
#2 – Promising an Unauthorized Amount of Options
Another common issue is when founders promise a certain share amount when they do not yet have an authorized option pool to promise from.
You just finished raising your Series A round, establishing a five-person board for your company, but you forgot to carve out an option pool in the round. Just after the round, you hire Bob as a front-end developer. You promise Bob 5,000 options in the company. Just like Suzy, Bob is excited and believes the options are finalized. You learned from your mistake with Suzy, and you want to issue Bob his options right away. However, you forgot to carve out the option pool in the round. On your next board call, you bring up the option pool and your promise to Bob for 5,000 shares, but your board decides against an option pool, and you and your co-founders don’t have majority control. You have now made a promise to Bob that you can’t keep. You must go back to him and notify him of this. Needless to say, Bob is not happy, and so much so that he quits.
Solution – Authorize before You Promise
Always make sure you have an authorized option pool of at least the amount of shares you are promising to new employees. This will help you avoid uncomfortable conversations and keep your employees loyal and happy!
Setting a Vesting Schedule as a Startup
Setting a vesting schedule as a startup or early-stage company is an important aspect of issuing stock options to your employees, as it has real implications both for your employees and for your company.
What Is a Vesting Schedule?
A vesting schedule is a time- or performance-based system determining when your employees may exercise their stock options. Once you issue options to an employee, those options will vest (meaning they will become exercisable) over time and per the terms set in the vesting schedule.
Example: You issue 10,000 options to your employee, with a four-year vesting schedule that is flat and time based. Once your employee has been with the company for one year, 25% of their options (2,500) will vest. When they reach their two-year anniversary, another 25%, and so on until the full 10,000 options have vested.
Pitfalls to Avoid
Now let’s look at some of the most common issues to avoid when it comes to setting a vesting schedule.
#1 – Failure to Set a Vesting Schedule
The first rule when it comes to vesting schedules is to set one. From time to time, we see founders issue options to employees with no vesting schedules. This effectively gives your employees the ability to exercise the options and receive stock on Day 1. While on the surface, this may not seem like a big deal. And it’s not, if your employee sticks around, but rarely are situations so picturesque in early-stage companies. If you don’t set a vesting schedule, then your employee can quit after a month and walk away with equity in your company. Not good!
#2 – Forgetting to Add Cliffs and Employee Requirements
A lack of employee requirements that protect the company in worst-case scenarios is a major stumbling block. These requirements range from basic no-brainers such as requiring that the employee remain with the company in order for their options to vest, to more complex requirements such as performance-based metrics.
One common clause we’d like to highlight is a cliff. A cliff is a minimum time period that the employee must remain with the company before any options vest. For example, let’s say you have issued options on a four-year flat vesting schedule, where 1/48th of the total options vest every month. It is common (and smart) to put a one-year cliff on the options so that no options vest for the first year, insuring the company against bad hires.
#3 – Setting a Non-Accelerated Vesting Schedule
The last pitfall we’d like to highlight relates to accelerated vs. non-accelerated vesting. In a nutshell, accelerated vesting means that in the event of a merger or acquisition event for the company, if you have employees still with the company whose options have not fully vested, those options get accelerated to vest upon the event. As a general rule, offering your employees accelerated vesting schedules will give them peace of mind that if they work hard and get the company to a sale before their options are fully vested, they will be compensated accordingly.
Setting an Employee Stock Option Strike Price
Setting a strike price is a delicate process and should be approached with a certain level of strategy, as a variety of issues arise by picking a number too high or too low. If your employee option strike price is too low, which is to say significantly lower than the fair market value, you will cause large adverse tax consequences for your employees, and can cause diligence issues in the mergers and acquisitions (M&A) process down the road. If your strike price is too high, which is to say unnecessarily higher than the fair market value, it will eat into the value of the options for your employees, and minimize or kill the incentive for them.
Pitfalls to Avoid
Now let’s discuss the most common problems founders face when setting employee stock option strike prices.
#1 – Setting It Yourself
We see this all the time. The founders want to issue options, but aren’t sure what the fair market value of their company is or how to set the strike price, so they just make up a number. Typically, they pick a very low number, to be favorable to their employees, and in many cases we will see strike prices of $0.01. While this may seem fine at a first glance, picking an employee stock option strike price in this way can cause serious issues. With a very low strike price, your employees will risk huge tax consequences, sometimes the options are even cancelled in audit. Plus, when M&A interest arises, low strike price options can be a red flag and kill the deal. Finally, the IRS can levy large fines to the employer for setting the option price too low.
#2 – Using a Funding Round
Another common method is to use the most recent funding round to set the valuation of the company and therefore the strike price. However, this puts your employees at a significant disadvantage. Some funding rounds close at a market valuation much higher than a fair market valuation, which takes into account many more variables. Many rounds also have preferred stock. In a liquidation event, the majority of the value is distributed to the preferred shareholders due to the capital structure making the value allocated to the common stock much less. Therefore, it would be inappropriate to price the shares the same. Using your funding round to set a stock option strike price can result in a very high price, sometimes many multiples higher, and this is bad news for your employees when it comes time to execute.
Solution – Getting a 409A Valuation from Trusted Experts
The best method for setting a strike price for your employee stock options is by obtaining a 409A valuation from a group of trusted experts. A 409A valuation is specifically designed to determine the fair market value for your company in the context of issuing options, and so it is positioned perfectly to both accurately value your company and give your employees the best strike price possible.
Setting a 409A valuation for your company is a straight-forward process, takes just a few weeks to complete, and will save you tons of stress and issues down the road. When it comes to obtaining a 409A valuation, there are three main factors to think about:
- Price – How expensive is the 409A valuation? Am I getting strong value?
- Time – How fast will I get my 409A valuation? What’s the turnaround time?
- Audit Defensibility – Is my 409A valuation audit defensible? What happens if I get audited?
Choosing Among 409A Valuation Partners
More often than not, you will need to settle on two of the three factors most important to you when deciding on a 409A valuation provider. Here are three tips on how to choose:
- Cheap & Quick – If price and time are most important to you in obtaining a 409A valuation, you should expect a lack of audit defensibility. This means that, in the case of an audit, the provider will offer no support for their valuation. This can result in the valuation being thrown out, causing significant tax consequences.
- Cheap & Defensible – If price and audit defensibility are most important, you should expect a significant time delay (in months not weeks) before you receive your 409A valuation. This can become a problem if you are looking to hire and issue options quickly after a funding round.
- Quick & Defensible – If time and audit defensibility are most important, you should expect a high price. This can be a great way to get a high-quality valuation, protect you against an audit, and allow you to hire and issue options quickly. However, prices can be more than $5,000.
Have Your Cake and Eat It, Too
When it comes to 409A valuations, Venture First believes you shouldn’t have to settle for just two out of the three. We strive to provide a high-quality, audit-defensible 409A valuation fast and for a price that doesn’t break the bank.
If you are interested in learning more about issuing employee stock options, setting a valuation schedule as a startup, or obtaining a 409A valuation, we’d love to connect! Give us a call at 502.208.2125 or email us at email@example.com today.
Originally published September 2016. Updated July 2021.