Tips for Creating an Employee Stock Option Plan

Creating an employee stock option plan is an important step in your business’ growth and a sign of its success. Though doing so is not particularly complicated, that doesn’t mean that the process should be pursued without ensuring all of the t’s are crossed and the i’s are dotted. Making sure that each step has been thoughtfully planned will save aggravation in the future, and the best way to do that is to bring in professionals with experience and expertise in how best to establish and manage the program.

Investing time and expense at the front end of the process may feel like a burden but doing so avoids the risk of unnecessary delays of an IPO or acquisition, or of violating regulations and the eventual fines and legal exposure that can accompany that type of mistake. The most essential assistance you will receive in this venture is the combined team of your attorneys and your financial advisors. The more careful and painstaking your process at the beginning, the more confidence your employees will have in the company’s future and value. Likewise, it is imperative that you continue to consult with those professionals as your company continues to grow, informing them of changes in your hiring plans and of offers made to new employees so that they can ensure your continued compliance with all pertinent laws and regulations.

First Steps to Creating an Employee Stock Option Plan

Once you’ve made the decision to create an employee stock option plan, you need to sit down with your founders, board, and advisors to discuss how the plan’s design can reflect your company’s mission and values; what the balance between cash and equity compensation will be; and how you will explain and offer the program to existing employees and to those you will hire in the future.

Though most regular stock grants and employee stock options are made available in lots of 100 shares, there is no requirement that you allocate them in that way. What is required is that once a plan is approved by the board and stockholders, it be formalized and put in writing.  Part of this process entails having your attorneys double-check that your plan is in compliance with federal regulations, as well as the rules for every state in which your employees live. Skipping this step can lead to headaches in the future.

What Happens After the Employee Stock Option Plan is Established?

Employee stock option plans are not self-sustaining. Failing to pay attention to what is happening or attending to cap tables can create just as many problems as not attending to details while initially setting it up. The best way to address this is to hire a reputable valuation company and schedule new valuations on a regular basis in keeping with IRS requirements. Benchmarks for valuations should include the program’s one-year mark and any major financial breakthroughs for the company.

There are numerous items your company will need to watch out for in order to ensure the health of your plan, including keeping an eye on your equity budget. Your hiring plan needs to coordinate with your funding events in order to ensure that adequate stock options are in reserve, and likewise your future plans will guide how many stock options you’ll need to set aside going forward. Failure to reserve adequate shares will require an adjustment approved by the board.

The Right Way to Offer Stock Options

Once stock options are available, you need to understand the correct way of offering them to employees and what pitfalls to watch out for. These include:

• Adequate shares need to be available or else the options will not be covered, and this could have a significant effect on what is being provided to the employee. Failing to adequately fund your equity budget makes you seem unreliable and may even put you in jeopardy of being sued.
• It’s also part of your responsibility to make sure that potential hires who would be offered options are legally able to work in the United States. If there is a question about a visa status or an employee’s citizenship or residency, you need to clear it up before hiring them.
• Grant size presents potential problems. If an individual employee’s equity represents more than ten percent of the company, you need to check the 409a share price valuation and make sure that your strike price is set at 110% instead of the 100% value that would normally be applied.
• Finally, never forget that you need to submit a comprehensive and detailed stock option grant letter that includes all details of your company’s stock option agreement. These details include the share value expressed by how many shares exist rather than percentage. The letter also needs to specifically indicate the requirement that the grant amount and exercise price is approved by the board before it is considered valid.

The Final Step

Every stock option grant must be approved by your company’s board, and if the stock options you decide to offer significantly differ from what has originally been agreed to, you need to ensure that the board approves of the changes. Once this approval is explicitly provided, the agreement can be processed and executed, and a copy given to the employee.

If the steps outlined here seem cumbersome and unnecessary, consider the consequences of failing to adhere to them. Carefully creating and administering an employee stock option plan is a high-value benefit that can attract top-shelf workers, but overlooking the required steps can lead to big problems. Pay attention to the details and you’ll find that you inspire continued confidence in your company from both your employees and your stockholders.

If you’re considering a stock option plan for your employees, please seek legal advice or contact our office to discuss the business implications.

Disclaimer: The information on this blog is intended to be educational so that interested parties can learn about interesting legal issues. No communication on this blog is in any way intended to provide any specific legal or other advice.