How to Create an Employee Stock Option Plan
While companies focus heavily on the fundamentals of running their business, they also need to have a comprehensive understanding of how to create an employee stock option plan correctly. From creating the plan to managing it, there are many details to address and monitor. Any missteps during these processes will almost certainly create serious problems for the founders and their board.
Companies that violate regulations for employee stock options can face fines and legal exposure. Financial problems and inconsistencies could delay an IPO or acquisition. If mistakes affect your employees’ grants, it will upset them and cause them to lose faith in your company.
You’ll need to rely heavily on your legal team when you offer employee stock options. While lawyers will take care of any legal tasks, you still bear the responsibility of informing them when your hiring plan changes or when you make an offer to a new employee. They won’t have the right information to help you if you don’t keep them informed.
It’s not overly complicated to create an employee stock option plan when you have the right tools. Take the process a step at a time to ensure that you’ve covered all of your bases.
Creating an employee stock option plan requires an upfront investment in time and expense, but it can cost substantially more later if you get it wrong.
Setting Up Your Employee Stock Option Plan
The first step in setting up your employee stock option plan is to develop your philosophy around your stock option plan. Generally, this should be a collaborative process between your founders, board, and advisors. The initial planning stage should include a discussion of how you plan to communicate the incentive to future employees. Your company’s mission and values should be a major factor in your stock option’s plan design.
Determine how much of the company you plan to share with early employees and employees that will join your company later. Regular stock grants are sold in shares of 100. Employee stock options are often allocated the same way, but companies have the option of allocating them differently. Stock option plans should also outline the balance between cash and equity compensation.
The final step in an employee stock option plan is formalizing the plan. Follow–through is key here. Put the plan in writing and get it approved by the board and stockholders. Consult with your lawyers to ensure that you have all the necessary state permits to comply with state and federal regulations. Various states have different regulations. If you have employees that reside in a state other than where your business is, you need to consult with your lawyers and make sure that you’re following the correct set of regulations.
Maintaining Your Employee Stock Option Plan
Once you create your employee stock option, you can’t set it and forget it. Be sure to know who is assigned to managing your cap tables.
Software by Diligent Equity will take the pain out of managing your cap tables. The software automatically updates your cap tables and prevents mistakes due to manual errors. By taking a proactive approach to managing your cap tables, you will be able to set an exercise price for your stock options that will be more likely to meet the IRS guidelines.
The IRS will give you positive marks for using a reputable valuation company. It’s also critical to pay attention to the required times for getting a new valuation. If your valuation is over 12 months old or if you hit a significant financial milestone, it’s time to get a new valuation.
A common mistake that companies make is not watching their equity budget closely enough. One thing to watch is your hiring plan, which should extend to your next funding event. Your hiring plan guide helps you to determine the number of stock options that you need to reserve to compensate new employees. The number of stock options will help you to create an appropriate-sized pool. It’s crucial to oversee your stock option allocation over time to ensure it will support future hires. If there appears to be a shortage in your equity budget at any point, you’ll need to take it to your board and rework it.
Making Offers of Stock Options
Companies also tend to make some crucial mistakes at the point of making offers of stock options to their employees. One of the common mistakes that companies make is not having enough shares allocated in the pool to make an offer to a new employee. Stock options that are uncovered are invalid. There are ways to repair this problem later, but it’s something that could impact the value of a new employee’s grant. Underfunding your equity budget can also expose your startup to legal liability.
Another important issue to watch is confirming that your employees have the legal right to work for you. It’s vital to confirm your employee’s residency and work visa status before making them an offer of work.
The size of your grants is also something to monitor. If any employee has total ownership or equity that reflects over 10% of the company, your strike prices must be 110% of the 409a share price valuation as opposed to the customary 100% value.
Still, another common oversight is that companies sometimes fail to offer a stock option grant letter that outlines the details of their stock option agreement. State the value of the shares in terms of the number of shares, rather than the percentage in the company that you’re giving them. An important point to take note of is that the offer letter should clearly affirm that the board must approve the grant amount and exercise price must be approved by the board before the offer letter becomes valid.
Finalizing Your Grants
Your company must follow through and ensure that the board approves each employee’s stock option grants. If you choose to offer stock options that are materially different from the standard company offering or vesting schedule, those changes must also be approved by your board. The final step is to process and execute the agreement. Follow through to the end and make sure to deliver the final, executed copy of the agreement to the employee.
Failing to create and administer your employee stock option plan correctly is bound to cause significant problems for your company. It’s worth the trouble to do it right from the start and it will discipline you to continue doing things right as a matter of course. Startups have a lot to prove in the beginning about how they handle all their business matters, including employee stock options. Having accurate, updated cab tables at all times demonstrates that you take every part of your business seriously and that you value your stockholders and employees.
