Ask the Business Attorney – What Is an Employee Stock Option?

by Scott Edward Walker on June 2nd, 2010


This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott


My co-founder and I are ready to hire a couple of key employees, and one of our advisors told us we need to set-up a stock option plan and offer the employees some stock options.  What is a stock option and what are some of the issues we need to worry about?  Thanks!


An employee stock option is a security which grants the employee-recipient the right to buy a certain number of shares of common stock of the company at a future point in time and at a price (i.e., the “exercise” or “strike” price) generally equal to the fair market value of such shares at the time of the grant.

The issuance of stock options is quite common in startups because it provides employees with an opportunity to benefit directly from the increase in the company’s value – creating extraordinary upside potential; it is appealing from the founders’ perspective as well due to the alignment of interests and the avoidance of any cash outlays.

Below are five significant issues that you will need to address in connection with the issuance of employee stock options.

1.  Vesting Schedules.  You should establish reasonable vesting schedules in order to incentive the employees to remain with your company and to help grow its business.  The most common schedule vests an equal percentage of options (25%) every year for four years, with a one-year “cliff” (i.e., 25% of the options vesting after 12 months) and then monthly, quarterly or annually vesting thereafter.  (Jeff Bussgang, a General Partner at Flybridge Capital Partners and a smart VC, recently discussed the issue of four-year vesting in his post “Stock vesting: Why is four the magic number?”.)

For senior executives, there is also generally a partial acceleration of vesting upon (i) a triggering event (i.e., “single trigger” acceleration) such as a change of control of the company or a termination without cause; or (ii) more commonly, two triggering events (i.e., “double trigger” acceleration) such as a change of control followed by a termination without cause within 12 months thereafter.

2.  Securities Laws.  As I have previously discussed, a company may not offer or sell its securities unless (i) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable State commissions; or (ii) there is an applicable exemption from registration.  Fortunately for startups, SEC Rule 701 provides an exemption from registration for any offers and sales of securities (including stock options) made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation, provided that they meets certain prescribed conditions.  Most states have similar exemptions, including California, which amended certain securities regulations in July 2007 in order to conform with Rule 701.

It is indeed imperative that you seek the advice of experienced counsel prior to the issuance of any stock options: non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the holders, injunctive relief, fines and penalties, and possible criminal prosecution.

3.  IRC Section 409A.  Under Section 409A of the Internal Revenue Code, a company must ensure that any stock options granted as compensation has an exercise price equal to (or greater than) the fair market value (the “FMV”) of the underlying stock as of the grant date; otherwise, the grant will be deemed deferred compensation, the recipient will face significant adverse tax consequences and the company will have tax-withholding responsibilities.

A company can establish a defensible FMV by (i) obtaining an independent appraisal; or (ii) if the company is an “illiquid start-up corporation,” relying on the valuation of a person with “significant knowledge and experience or training in performing similar valuations” (including a company director or employee), provided certain other conditions are met.

4.  Size of the Option Pool.  As many entrepreneurs have learned (much to their surprise), venture capitalists impose an unusual methodology for calculating the price per share of the company following the determination of its pre-money valuation — i.e., the total value of the company is divided by the “fully diluted” number of shares outstanding, which is deemed to include not only the number of shares currently reserved for in an employee option pool (assuming there is one), but also any increase in the size (or the establishment) of the pool required by the investors for future issuances.

The investors typically require a pool of approximately 15-20% of the post-money, fully-diluted capitalization of the company.  Founders are thus substantially diluted by this methodology, and the only way around it is to try to keep the option pool as small as possible (while still attracting and retaining the best possible talent).  When negotiating with investors, entrepreneurs should therefore prepare and present a hiring plan that sizes the pool as small as possible; for example, if the company already has a CEO in place, the option pool could be reasonably reduced to closer to 10% of the post-money capitalization.  (There is an outstanding post “The Option Pool Shuffle” by Nivi of Venture Hacks, which discusses this issue in detail.)

5.  Restricted Stock.  Finally, depending upon the stage/value of your company, you should consider issuing restricted stock to the employees in lieu of stock options for three principal reasons: (i) restricted stock is not subject to Section 409A; (ii) restricted stock is arguably better at motivating employees to think and act like owners (since the employees are actually receiving shares of common stock of the company, albeit subject to vesting); and (iii) the employees will be able to obtain capital gains treatment and the holding period begins upon the date of grant, provided the employee files an election under Section 83(b) of the Internal Revenue Code.

The downside of issuing shares of restricted stock is that upon the filing of an 83(b) election (or upon vesting, if no such election has been filed), the employee is deemed to have income equal to the then fair market value of the shares.  Accordingly, if the shares have a high value, the employee may have significant income and perhaps no cash to pay the applicable taxes.  The other downside is compliance with applicable securities laws (as discussed in paragraph #2 above).


I hope the foregoing is helpful.  The takeaway (which may sound a bit self-serving) is that you need to get experienced counsel involved early on to address the foregoing issues.  Indeed, there are generally three documents that must be drafted in connection with the issuance of stock options: (i) a Stock Option Plan, which is the governing document containing the general terms and conditions of the options to be granted; (ii) a Stock Option Agreement to be executed by the company and each optionee, which specifies the individual options granted, the vesting schedule and other employee-specific information (and generally includes the form of Exercise Agreement annexed as an exhibit); and (iii) a Notice of Stock Option Grant to be executed by the company and each optionee, which is a short summary of the material terms of the grant (though this is not a requirement).

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