Start-Ups: Be Careful When Granting Stock Options

Every employer hopes to attract the most talented and dedicated workforce. That’s the reasoning behind offering incentives such as benefit plans and stock options. Where start-ups are involved, stock options can provide a good solution for both the employer and the employee.

However, this strategy is not as simple as it might seem. While based in sound reasoning and good intentions, it’s important that start-up companies proceed with caution when offering stock options to employees. From impacting the growth of the company to de-incentivizing workers, numerous unintended consequences can arise.

That’s not to say that offering stock options is a bad idea for new companies. But they must take care to avoid common problems related to stock options. Here are six initial steps that can provide guidance.

Option Plan. Stock options must be granted under an Option Plan approved by the board and the shareholders, otherwise any purported grants are invalid.

Seek and obtain board approval. Stock options must be approved by the company’s board in order to be properly granted. Otherwise, you could find yourself stuck at some point in the future; grant the promised stock at a now-higher price, or admit to disappointed employees that you made a mistake?

Grant stock options at fair market value. Stock option grants must be made at fair market value (usually determined on the date the board approves the grant). Failure to take this simple step can result in excessive taxation by the IRS later, and your employees are unlikely to appreciate that.

But because shares of a start-up are not yet publicly traded, valuation can be a tricky proposition. The safest course of action is to retain an outside firm to perform a valuation in compliance with Section 409A of the Internal Revenue Code. Doing so shifts the burden of proof to the IRS, rather than the company.

Renew the valuation report in a timely manner. Now that you’ve received your 409A valuation report, it must be routinely renewed at least every 12 months. And at any time that the company is experiencing a “material change,” the 409A report must once again be renewed. This will entail suspending new stock option grants until a fundraise or major transaction closes. Otherwise, your employees could once again be subject to unfair tax consequences.

Follow securities law to the letter. Federal securities law prohibits the selling of securities to the public without first registering the stock with the SEC. Rule 701 does provide an exemption to this rule, for private companies who want to offer stock options to employees, but strict limits must be followed. Careful consultation with a business planning attorney is advised to avoid violations of this rule.

Only grant stock options to people. Rule 701 also specifies that stock options are for people only, not LLCs. Yes, you can grant stock options to independent consultants, but only to them personally and not to their legal entity.

If you want to grant stock options to some organization other than an individual, consult an attorney about doing so.

As with most things involving business planning, consultation with an attorney before making any promises would be wise. Call our office to discuss your plans. We can help you maximize the impact of granting stock options while avoiding any potential legal or financial complications.

Picture of Michael Kimball, Esq.

Michael Kimball, Esq.

Mike Kimball offers practical, timely, and economical legal solutions that move projects along and allow you to focus more on your core business objectives. He has years of experience partnering with companies ranging from Silicon Valley startups to firms in aerospace, biotech, construction, and many more. Mike’s in-house experience includes Yahoo!, Krux Digital (acquired by Salesforce), and Commerce One. He has worked on transactions with Eurostar, Red Bull, Major League Baseball, NASDAQ, Goldman Sachs, Liveramp, Amazon, and NASCAR.