Create a stock option plan

Create a Stock Option Plan

If a company wants to incentivize employees or outside contractors to help the company grow, it should create a stock option plan (also known as an equity incentive plan). A stock option plan allows a company to give its employees or contractors stock options in the company or other types of awards — more on the different types of awards is below — so that they’re incentivized to contribute their time to the growth of the company and, if all works out, a nice payout down the road in the case of an acquisition or other sale of their equity. In other words, a stock option plan is intended to give service providers the right to purchase shares of a company at a low price so that they can sell those shares later on when they’re worth more. The company wins by not having to pay those service providers cash as compensation — the company pays the service providers in equity instead — and the service providers win by buying shares at a low price and selling the shares later at a higher price.

When to Create a Plan

A company ideally will put its stock option plan in place not long after being formed. That’ll ensure that there’s an agreed upon amount of shares — a stock option “pool” — set aside at the outset, which can be tapped into by the company whenever its board chooses to make awards under the plan. For example, assume a company is formed as a C Corporation and the founders decide to authorize 10,000,000 shares. The founders might issue out to themselves 7,000,000 shares as founders’ stock and set aside 3,000,000 shares for the option pool — in other words, a 30% option pool. As time goes by, they can use those 3,000,000 shares to make incentive awards under the plan.

Another advantage of putting a stock option plan in place early is that it will be complete when the company starts looking for funding from outside investors. As a general rule of thumb, it’s easier to explain the existence of a stock option plan to new investors in advance, rather than later asking them for permission to put a plan in place (depending on the type of investment and type of investor, the investor may want to vote on whether a company can authorize a stock option plan at all).

Different Types of Plan Awards

There are a variety of awards that can be granted under a stock option plan. The most common ones — at least in our experience — are restricted stock, incentive stock options (“ISO’s”), and non-qualified stock options (“NSO’s” or “NQSO’s”). Here’s a brief summary of the differences between each of these awards:

Restricted stock:

• This is actual stock in a company. Unlike options, the recipient doesn’t later have to exercise the award in any way. Instead, the stock immediately becomes the property of the recipient as soon as it vests, or, if there are no vesting terms, then it immediately becomes that person’s property when awarded.
• If there are vesting terms, then the recipient should definitely consider making an 83B filing, to avoid any tax surprises later on.
• Unlike stock options, recipients of restricted stock often pay for their awards up front, since they are actually receiving stock and not simply receiving an option to later purchase stock. The amount paid will depend on the company’s fair market valuation of the stock when the award is made. Unless the amount is minimal, companies often allow recipients of these awards to pay for their stock with promissory notes that have minimal interest rates and which only mature under limited circumstances, such as the company being acquired or going public, or the termination of the recipient’s services to the company.
• Unlike stock options, restricted stock awards are not subject to 409A valuations (more on those below).

Incentive stock options:

• They can only be granted to employees.
• The strike price (also known as the “exercise price”) of the option must be at least equal to the fair market value of the underlying stock — usually the underlying stock is common stock — when the award is made (or 110% of the fair market value for shareholders who own over 10% of the company at the time that awards are made to such shareholders).
• The recipient of an ISO award can only have $100,000 worth of ISOs vest in a given calendar year (or else they’ll be treated as NSO’s).
• There is no tax at the time of the award or at the exercise of the option.
• The recipient of the option must wait at least (a) two years from the award date and (b) one year from the exercise date, before selling the shares. Otherwise, upon the sale, the recipient will have to pay ordinary income tax on the difference between the value of the stock at the time of exercise minus the value when the award was made and capital gains tax, if applicable.

Non-qualified stock options:

• They can be granted to anyone (both employees or outside service providers).
• There are no restrictions on strike price, but it’s best to set the strike price at the fair market value.
• There is no tax at the time of the award, but, upon exercise of the option, the recipient will have to pay ordinary income taxes on the difference between the value of the stock at the time of exercise minus the value when the award was made.
• After exercising the option, the recipient may immediately sell the shares (provided that the company doesn’t otherwise contractually restrict the recipient from selling the shares — companies often subject the shares to a right of first refusal).

STOCK OPTION PLAN COMPLIANCE ISSUES

Companies issuing awards under stock option plans will need to comply with tax and securities laws. From a tax perspective, if the company intends to issue options, it will need to set the strike price for the options — this is what’s referred to as a 409A valuation — at an amount that’s at least equal to the fair market value of the underlying shares at the time of the award. There are a LOT of companies and service providers that offer 409A valuations, so it’s not hard to get a valuation completed. The valuation will be easier if the company is young and does not have much of an operating history. It may even use free resources to complete the valuation itself.

From a securities law perspective, the plan, if correctly drafted, should qualify as a Rule 701 exempt employee benefit plan. That means the company won’t need to make any filings with the SEC, but it may need to make “blue sky filings” in the states in which recipients receive awards under the plan. Before issuing awards under a stock option plan, companies should first review the state securities laws in which recipients reside to ensure the company is aware of, and will be able to comply with, state filing requirements and deadlines.