What are the common mistakes when issuing stock options to employees? Stock options have become an integral part of compensation in the market. Today, many employees expect to get stock options when joining an organization. However, the process of issuing stock options is not easy and there is the risk of serious mistakes at the time of issuance. The companies issuing stock options for the first time are especially prone to making mistakes when issuing stock options.
Any mistakes made when issuing stock options to employees can result in problems that can have deep and long financial implications for the company. So while stock options are a great way to attract and retain employees for startups, there are also risks involved in issuing stock options if not done properly.
So if you are about to start issuing shares to employees, then it is best to be aware of the common mistakes made by companies at the time of issuing options. Knowing these mistakes will not only help make sure you don’t make them but also make the process of issuing options easier.
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Here is the content that we will cover in this post. Let’s get started.
- 1. What are stock options?
- 2. How do stock options work?
- 3. What are some common mistakes to avoid when issuing stock options to employees?
- 4. Not getting approval from the board of directors
- 5. Putting all stock options under the same umbrella
- 6. Not drafting formal grant documents
- 7. Exceeding the stock options pool when granting options
- 8. Issuing stock options at the wrong time
- 9. Failing to get a valuation
- 10. Not tracking the vesting schedule of stock options
- 11. Issuing stock options to an entity
- 12. Conclusion
What are stock options?
Stock options are a form of equity compensation where the company grants its employees a right to buy shares at a special price. So the incentive stock options offer to employees is that they have an option to buy the company’s stock at a lower rate compared to the market value of the shares. Of course, stock options only become exercisable once a fixed amount of time has passed.
It is important to mention that when an employee receives stock options they don’t get a certain number of shares, but they only get the opportunity to buy shares at a discounted price. Stock options have the potential for increasing the net worth of your employees significantly as the value of the company’s stock grows over time.
When employees have stock options, they have an incentive to contribute to the growth of the company. At the same time, the employer has a chance to retain talented employees at least until their options become exercisable. But despite the main positives, you must take the time to understand the common mistakes when issuing stock options to employees.
Working out how to pay and retain top talent when the company is yet to make good profits is only one of the startup hurdles every entrepreneur needs to overcome. Check out this video I have created explaining in detail what are the other challenges you might face and how to deal with them.
>How do stock options work?
Stock options are valuable to employees because instead of buying the stock of a company from the open market, they get the option to buy it at a lower price. However, as mentioned above, stock options only become exercisable after a certain amount of time known as the “vesting period” has passed. The vesting period is the major way companies make sure that they can retain their employees through stock options.
So if you issue stock options to an employee with a 4 year vesting period, then the employee gets the right to exercise a certain percentage of the stock options each year. So the employee will have to stay employed for the four-year vesting period before all the stock options can be claimed by the employee.
Different companies use different vesting periods, so you can easily increase or decrease the amount of time the employees have to remain employed in order to vest their stock options.
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>What are some common mistakes to avoid when issuing stock options to employees?
Now that you know what stock options are and how they work to improve employee retention, you would probably know why they are so popular among employers and employees alike. With that said, issuing stock options without the appropriate planning can do more harm than good for the employer.
To help make sure you don’t repeat the mistakes that companies have made when issuing stock options, let’s dive deep into some common mistakes that companies make when issuing options to employees, so keep reading.
>Not getting approval from the board of directors
The board of directors has a say when it comes to issuing stock, and stock options are no exception. Before you can start issuing stock options, you have to get written approval from the board of directors. In a scenario where there is no approval by the board of directors, you can’t issue stock options.
A lot of companies make the mistake of not getting approval from the board of directors before issuing stock options. Every stock option has to be granted directly by the board of directors through written consent and if no approval was taken by the BOD, stock options will not be considered valid.
If a company makes one of the most common mistakes of issuing stock options to employees without the approval of the board, they will have to reissue stock options which can make them less attractive to employees. Reissuing stock options when the stock price of the company has gone up will mean that employees won’t be able to buy the stock at a low price. This can result in reduced employee retention rates because the employees won’t see the benefit of sticking around only to be able to buy the stock at a higher price.
So if you are about to issue stock options, make sure you get approval from the board of directors before doing so. One way to avoid this mistake would be to set up a board consent procedure that allows the BOD to approve stock options via email without holding meetings every time they need to approve them.
>Putting all stock options under the same umbrella
Another common mistake companies make when issuing stock options is that they consider all stock options as the same. However, the truth is that there are different types of stock options, more common being the incentive options (ISO) and non-qualified stock options (NSO).
Both types of stock options are different in the way they are taxed and also to who they can be issued. Both of these stock options types have their advantages and disadvantages, so if you aren’t aware of the differences between the two you can end up issuing the wrong type of options to employees.
Issuing the wrong type of stock options can mean that the employees have to pay significant taxes on the options when they exercise them. At the same time, ISO is reserved specifically for the employees while NSO can be issued to employees, advisors, consultants, and even contractors of the company.
So it is essential to do some research to find out about the different types of stock options before you issue them. Knowing about the types of stock options and the advantages and disadvantages of each type can make sure that you issue the right stock options. This information will help you avoid the common mistakes when issuing stock options to employees.
>Not drafting formal grant documents
When you hire an employee and want to grant them stock options, you need to make sure you draft formal grant documentation and deliver it to employees. Failing to draft and deliver stock options grant documentation to employees can cause legal and administrative issues down the road.
Grant documents contain information such as vesting schedules, expiration, and the termination period of the stock options. In case you fail to deliver the grant documentation to the employees at the time of issuing options, you can’t enforce the terms of the options. Not to mention, employees will have a difficult time tracking the vesting period and other aspects of their options if they aren’t made official in a grant document.
Therefore, it is essential to draft and deliver the appropriate stock options grant documentation to employees in order to avoid legal and administrative issues.
>Exceeding the stock options pool when granting options
Another common mistake made by companies when granting stock options is issuing stock options without considering the pool of shares reserved for the purpose. The board of directors reserves a specific amount of shares, and you can’t exceed the reserved pool of shares when issuing stock options.
The Board of Directors specifies the pool of shares to prevent dilution of the company’s stock. So if you are issuing too many options to employees without considering the reserved pool of shares, you can discourage investors by making shares less valuable.
Usually, companies set aside 20% of their total stock to be issued as stock options. However, you can reduce the percentage of shares that make up the stock options pool to prevent dilution of stock.
>Issuing stock options at the wrong time
Stock options are mostly issued by startups before they go public because that is when they can offer a low exercise price to their employees. However, once the company has received its investor term sheet, the exercise price can go up making stock options less attractive for employees.
Most companies end up issuing stock options at the wrong time and end up paying the price of their mistake in the form of high employee turnover. If you are issuing stock options after receiving your investor term sheet, your employees won’t be able to benefit from the low exercise price.
So in short, issuing stock options at the wrong time can reduce their effectiveness. Therefore, it is best to issue options at earlier stages of your company to make sure your stock options hold a low exercise price. Take care to avoid one of these common mistakes when issuing stock options to employees.
>Failing to get a valuation
Certain IRS laws regulate stock options. As per IRS rules, companies must issue stock options with an exercise price that is equal to, or greater than the market value of the company’s stock at the time of issuance.
So if you don’t get a 409A valuation and set a valuation for your stock by yourself, the IRS will not accept such a valuation. On top of that, your employees and organization may be subject to tax penalties by the IRS if you issue options without a valuation.
Even if companies get the first valuation, they often make the mistake of thinking the initial valuation is enough to stay compliant with IRS laws. You have to get a fresh valuation for your company’s share value at least once a year to stay compliant.
>Not tracking the vesting schedule of stock options
Each employee that gets stock options granted to them will have a unique vesting schedule for their stock options. However, oftentimes companies make the mistake of not tracking the vesting schedules for each employee only to run into issues when the employee wants to leave the company and decides to exercise the vested options.
If you aren’t tracking the vesting schedules of each employee’s options, there is no way to tell what percentage of options an employee has vested at a certain point. Not to mention, employees can’t track their own vesting progress if they don’t have a clear vesting schedule to follow.
You can use automated tools that track the vesting schedule of each employee, and you can send regular email updates to employees regarding their vesting progress.
>Issuing stock options to an entity
A less common mistake related to the issuance of stock options is issuing them to an entity. Sometimes companies may want to issue stock options to a consultant’s LLC, which counts as an entity and not a person.
Issuing stock options to an entity can make the grant invalid, and if you want to do so, it is important to consult a legal expert. A lawyer can make sure if relevant exemptions can be applied that validate the issuance of stock to an entity.
However, in most cases, you can’t issue stock options to an entity, and you will need to grant them some other form of equity outside of the options pool.
Most large companies have legal advisors that can correct them if they are making a mistake during the stock options’ issuance process. However, small companies, especially startups, don’t have the expertise or the experience to help them in avoiding these mistakes.
Now that you know the common mistakes when granting options to employees you can make, work out how to steer clear of them.
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