Creating Incentive Stock Option Plans

The appeal of stock options for startups and earlier-stage companies may not be what they once were, but there remains a high expectation on the part of your best employees that they will one day share in the runaway success of the firm. Stock options, particularly those that are fully vested, are a significant motivator, ensuring that employees are aligned with the long-term goals of the company.

Your chances for attracting and retaining the top tier people you need for success are much better with some up front equity budgeting by founders and careful annual thinking about the equity pool you’ll need going forward for both new hires and merit-based awards to existing key contributors.

Incentive Stock Option (ISO) Plans remain an important retention and motivation strategy. There is room to get creative with ‘synthetic’ options and bonuses tied to successfully completed projects and key milestones. By offering these options, companies can manage the exercise price effectively, ensuring it aligns with the price and the fair market value of the company shares at the time of grant.

Equity Still Matters

As unicorns and IPOs have become more rare, the appeal of stock options for startups may not be what it once was, but ISOs remain table stakes for startups that want to draw exceptionally talented people. The favorable tax treatment of ISOs, especially when compared to the alternative minimum tax, makes them a more attractive option for employees.

There is more inherent power and flexibility in ISOs for recruiting and retention than many founders may realize. Also, a management team can get extraordinarily creative in using synthetic and restrictive options based on the successful completion of a particular project or initiative. This creativity can extend to managing the expiration date of options to maximize their benefit to both the company and the employee.

Founders’ Equity

Founders are generally good at thinking through equity allocations among themselves, but something easily overlooked in the early capitalization structure is model options for new employees. Understanding the impact of equity grants on future dilutive events is crucial, particularly in how they relate to qualified stock options and their tax implications, including long-term capital gains considerations.

The size of the initial option pool you need available depends on the executive team you have on hand and those you will need. For example, if among your founders you already have your CEO, COO, CTO, and other key executive team members, you may only need a pool of 10-12% of fully diluted shares available to create a suitable equity compensation plan. However, if you are yet to bring on several key members of your executive team, you may need 15-17% or more of fully diluted equity in the equity pool. I’ve seen founders caught off guard because they needed to come up with 5% equity for the CEO they really wanted.

The earlier an equity incentive plan reserve can be built into an equity strategy, the sooner it can be leveraged, usually in the form of winning a star employee through the draw of equity (in exchange for a lower salary).

Budgeting for Equity

Building the Organization You Want

In addition to the executive team, you will need to think through your organization as it is and how you ideally want it to be. A good practice is to map out an entire organization chart and then do a bottoms-up budget for granting equity throughout the entire organization. Budget out at least two years or to the next anticipated equity raise, ensuring the income tax rate implications are considered for each equity grant.

One example – and this is merely an illustration as equity grants have many moving parts and variables – is if you anticipate the need for a great software engineering team, you may allocate for your Engineering VP 1%; a senior engineer 0.5%, and a line employee 0.25% (of fully diluted shares outstanding). Go through the same exercise for sales, marketing, operations, and other functions. To avoid confusion at the time of future dilutive events, it is always prudent to detail option grants as a specific number of shares versus a percentage.

Again, not only do you want to create a pool of equity for new hires, but for merit awards; particularly if your horizons for major events (such as IPO or an M&A transaction) stretch beyond 3-5 years.

Common Forms of Equity Incentives

The most common forms of equity incentives for the employees of startups are stock option plans, stock grants, and stock purchase plans.

Stock options are the most common and preferred form of equity-based compensation. A stock option gives the employee the right to purchase stock of the employer or its parent corporation. Stock options typically are granted to employees subject to vesting requirements, which prohibit exercise of the unvested portion of the option prior to completion of specified employment or service requirements (or may permit immediate exercise but with the stock subject to a repurchase right on the employer’s part that lapses over the vesting period in a manner similar to restricted stock).

An employee will generally receive one of two types of stock options: Incentive Stock Options (ISOs) or Nonqualified Stock Options (NSOs).

ISOs

Employees are typically granted ISOs, which must be granted subject to a formal stock option plan and are subject to certain restrictions. ISOs have favorable tax treatment for the recipient in most cases, often leading to long-term capital gain taxation rather than ordinary income tax rates. To ensure ISO treatment of option grants by the IRS, the company should follow certain rules to properly grant stock options to its employees including but not limited to having a valuation of its common stock performed on at least an annual basis or more often if material changes to the business have occurred. Improper option issuances may lead to unintended tax liabilities for both the company and the employee.

NSOs

NSOs are often issued to non-employees such as consultants, who are not eligible to receive ISOs or participate in statutory employee stock purchase plans, and to key employees or directors to whom the company wishes to grant options.

Assuming that the NSO does not have a “readily ascertainable value” at the time of grant (and virtually no NSOs do), there are no tax consequences for the optionee at the time of grant.

Rules of the Road for ISOs

1. Stock Option Plan must be in writing;
2. Stock Option Plan must be approved by the shareholders of the company within twelve months of the plan’s adoption by the board of directors (the plan may also be approved up to twelve months prior to adoption by the board);
3. Options must be granted within ten years of the formal approval of the option plan;
4. Options must expire less than ten years from issuance (or five years from issuance for any holders of more than 10% of the company’s stock);
5. Options must be granted only to employees of the company (not to directors or consultants);
6. Options must be exercised within ninety days of termination of employee status or one year following the death or disability of the employee;
7. The value of the stock to vest in any one year under the option (based on the value at the grant date) shall not exceed $100,000; and
8. Options may not be transferable except in the event of death by will or laws of distribution of assets.

Incentive Projects

For companies with major milestones such as clinical trials and securing regulatory approval, incentives, and stock options can help motivate and direct work toward specific outcomes.

Whether you incentivize key contributors or energize projects, Incentive Stock Option Plans remain an important retention and motivation strategy. For detailed plan development, schedule a call with us.