Issuing stock options to your employees is a great way to attract new talent and increase retention. However, it’s a complex and delicate process, and small errors early on can quickly balloon into expensive, time-consuming problems down the line.
That’s why it’s important to understand the most common mistakes founders make when issuing options. By avoiding these basic pitfalls, you can create a stock option plan that both keeps you compliant and properly incentivizes your team.
1. Getting the timing wrong
Once you’ve decided to grant options, it’s critical to make sure you time these issuances correctly.
For example, issuing options late (e.g. after you’ve received an investor term sheet) may force you to grant those options at a higher exercise price than you originally promised to your employees. As a result, they may be less motivated to exercise their options, or even worse, feel uninspired to stick around.
That’s why it’s often a good idea to issue stock options before you have a term sheet in-hand. By doing this, you allow your employees to take advantage of a lower exercise price.
2. Failing to get a 409A valuation (or update your previous one)
Before issuing options as a private company, you need to get a 409A valuation to determine the fair market value (FMV) of your company’s common stock. This FMV helps you set the strike price, or the legal purchase price for each share.
If you don’t have a valid 409A valuation on file when issuing options, you risk exposing your company and employees to all sorts of potential tax penalties from the IRS. For example, if you issue options with a strike price that’s lower than the legally-defined FMV, your employees could be charged significant interest penalties.
A one-time valuation also isn’t enough. To avail yourself of the 409A safe harbor with the IRS, you need to get a new 409A valuation every 12 months, or sooner if you have a material event or transaction, (like a new financing round).
For these reasons, it’s critically important to stay on top of your 409A valuations. At minimum, make sure you have a new valuation on the calendar every 12 months, and if you’re in the middle of a major transaction, postpone any new option issuances until you have an updated valuation on file.
3. Not getting board approval for issuances
Another mistake many early founders make is issuing options without their board’s approval first. The board has to approve all stock option grants ahead of time, either at a board meeting or by unanimous written consent. If your board hasn’t approved an option grant, no options have actually been granted.
By the time you realize this as a founder, it could be too late. You may need to re-issue the stock options, and depending on how much your company’s value has grown between now and then, these new options could end up carrying a higher exercise price than you originally promised your employees.
Luckily, you can avoid this problem by setting up a standard board consent procedure for stock option approvals. And you don’t even have to schedule formal meetings. With the right software, such as Carta, your board members can approve option grants via email.
4. Thinking all stock options are the same
There are a few different types of stock options you can issue—each with their own implications for your business and employees.
The most common types are incentive stock options (ISOs) and non-qualified stock options (NSOs). They differ in a few ways, namely: 1) whom they’re for and 2) how they’re taxed.
ISOs can only be issued to employees, whereas NSOs can be issued to employees and advisors, directors, consultants, and contractors.
In general, ISO holders don’t have to pay taxes when they receive a grant or exercise their options (though some may have to pay the alternative minimum tax). NSO holders, on the other hand, have to pay taxes when they exercise and when they sell. Because ISOs can have special tax advantages, employees tend to favor them and may be more likely to exercise knowing they have an ISO.
However, there are also advantages and disadvantages for your company. For example, employers generally can’t take a tax deduction with ISOs, but they can with NSOs. When deciding which type to issue, make sure you consider your long-term company goals and employee needs.
5. Failing to correctly track vesting schedules
Neglecting to create a proper vesting schedule can have dire consequences for your company’s retention and cap table.
If employees don’t understand how vesting works or can’t track their own progress, they may be less motivated to stick around until the end of their vesting period. And if an employee leaves your company with their options only partially vested, it’s difficult to work backward to make sure the unvested shares are properly reconciled on the cap table.
Setting a vesting schedule and tracking it, however, can help. There are two types of vesting:
Cliff vesting is when employees receive 100% of their stock options all at once after a stated period of time.
Graded vesting is when employees receive a portion of their stock options gradually over a certain number of years until they’re fully vested.
Whichever route you pursue, make sure you implement a smart tracking and update system. That could involve hosting a quarterly equity education training for employees; sending employees emails before and when they hit vesting milestones; and tracking employee issuance dates and vesting progress on your cap table.
Setting your company up for success
Making mistakes when issuing options can cost you time, money, and in the worst case, valuable employees. To avoid inadvertently complicating your cap table or de-incentivizing your team, it’s important to make sure all your ducks are in a row before you issue stock options.
In addition to consulting your lawyers, consider investing in an equity management platform like Carta. As a founder, you can set up your cap table, issue electronic securities, request 409A valuations, and even get easy board approvals. Plus, it’s simple for your employees, too. They can accept electronic securities, exercise their options, and view their vesting schedules all in one place.
The result? You’ll stay compliant, and your employees will have all the stock option information they need right at their fingertips.