There are many reasons to grant stock options, but the general purpose is to attract, retain, and motivate the people who are expected to make important contributions to your company. The Stock Incentive Plan (“Plan”) is the vehicle used to grant company equity to eligible grantees. The Plan lays out all of the rules for how stock options and restricted stock (and other types of equity awards) can be granted and repurchased by the company. It also includes the document templates (“Grant Forms”) that will be used when granting the equity awards. The Plan must be approved by the Board of Directors. The company’s Stockholders must also approve the plan in order to satisfy certain tax requirements.
Although there are several forms of stock grants, we will focus on Incentive Stock Options and Non-Qualified Stock Options, which are most popular among startups. Both have their own set of rules and tax implications. It is important to consult with your counsel to understand which type of stock award will be best for your employees, consultants, advisors, and your company. Although there are many differences between them, the major distinctions are 1) who is eligible, 2) how the taxes are handled, and 3) the rules around transferability and repurchase.
Incentive Stock Options (ISOs) are only available to company employees. Non-Qualified Stock Options (NQOs) are available to a wider audience: employees, advisors, and consultants.
OK, so now that you know what you can do with your Stock Incentive Plan, what do you need to know to set one up? A couple things. Some may be easier to decide than others. If you’re not sure, this is a great time to touch base with your counsel for some legal advice.
The first thing you’ll need to decide is the number of shares of common stock you want to allocate (the “Pool”) for issuance under the Plan. The ideal number of shares to be allocated is subject to many factors, including your total number of issued and outstanding shares and your fundraising strategy. The general rule of thumb is to keep it as small as you can while allocating enough shares to attract and retain talent, in the area of 5%–20% of your current issued and outstanding shares.
Why is smaller generally better? When your company is going through a financing, the size of the Pool is often up for negotiation. For instance, your investors will likely require an increase in the Pool on a pre-money basis (i.e. your dilution, not theirs). Needless to say, the negotiation behind this aspect of a financing can be complicated and, again, varies widely company to company. Deciding the amount of stock to allocate to your Pool is one of those “seek counsel” areas—it’s highly recommended you do just that!
The Grant Forms are used in the administration of the Plan, and offer an opportunity to standardize certain terms of the equity grants you issue. The areas listed below can be changed on an individual grant basis as needed, but are proposed as generally agreed upon defaults. Here are some of the basics you’ll need to consider for the Grant Forms:
- Vesting—Among other things, vesting encourages retention. If a grant is subject to vesting, the grantee accrues the right to exercise their stock options over time, typically four or five years from the vesting commencement date, with a predetermined frequency (yearly, quarterly, etc.). If the grant has a vesting cliff, there will be an initial period of time before which no options are vested, typically one year (i.e. a one year cliff). The net result is that if they depart the company before the end of the cliff, no options have vested. However, if they are still associated with the company at the end of the cliff, the grantee receives all of the stock options that have accrued in the time between the vesting commencement date and the end of the cliff.
- Permit Early Exercise—Early exercise allows the grantee to exercise (purchase) stock options that have not yet vested. The company maintains the right to repurchase the unvested portion of the grant when the employee is terminated. The early exercise option has advantages and disadvantages for employees and companies since the grantee will be considered the legal owner of the shares for tax purposes and voting rights. Early exercise typically raises the question whether an 83(b) should be filed. This requires extra attention as the 83(b) must be filed within 30 days of the exercise—no exceptions.
- Acceleration Clause—An "Acceleration Clause" establishes the circumstances under which the vesting of some or all of the granted equity might immediately vest (such as upon a sale of the company or termination without cause). Acceleration should be discussed with your counsel if you think it may be appropriate for your company.
The process of setting up a Plan prompts important business decisions about how equity will be handled. Establishing the defaults for the Grant Forms lays the foundation for granting equity awards in a manner that is consistent and fair—though still flexible for exceptional situations. Once approved, the company can begin granting equity awards to attract talent, build loyalty, and reward the individuals who make a difference in your company.