What are some of the things I should consider when setting up a stock option plan?

QUESTION:

My startup is considering setting up a stock option plan for our employees. What are some of the things I should consider when setting up a stock option plan?

ANSWER:

Dan Walter

Dan Walter

by Dan Walter, CEO of Performensation

Please note that this answer is not comprehensive, but should provide some highlights on this topic.

Rolling out a stock option plan under current regulations requires an understanding of SEC, Tax, Accounting rules in conjunction with human capital and engagement practices. It is complex process that one should consider carefully before going it alone.

1. Percent of company value to dedicate to equity compensation. The amount of ownership that you are willing to dedicate to employee equity

2. Exit Event. Potential monetization events that will allow employees to extract money from their equity. Among these are: IPO, Acquisition, Merger, Purchase, Secondary Market, Internal (company controlled) market.

3. Laws for Issuance and taxes. States and Countries where your employees reside. Many states and all countries will have there own securities rules. There are also tax rules and accounting rules to consider.

4. Impact on Dilution. The impact of stock options on dilution and/or valuation of your company.

5. Company Valuation. Process for valuing your company and its underlying stock. This is required under IRC 409A. It often requires an outside valuation professional.

6. Policies for: Termination (voluntary and not), Change in Control, Retirement, leaves of absence.

7. Ownership. When to allow for employees to become actual owners of stock and how that ownership will impact your company. >499 shareholder generally results in required SEC filings, or a lot of legal work to attempt an exemption. Each new shareholder means one more person at meetings and votes. Shareholders have far more rights than holders of unexercised options.

8. Type of equity. Stock options are good, but not always right for every company. There are many reasons to consider Restricted Stock Shares and Units, Stock Appreciation Rights, Phantom Stock, Performance Units and more…

9. Vesting Schedule and exercisability. Historically 3-5 for stock options and 2-4 years for Restricted Stock Shares or Units. The correct vesting schedule for your company may not be as simple as this. You may have more than one standard schedule or may allow for more frequent vesting once the employee reaches a time threshold.

10. How much information are you willing to share with employees and how will they find value in their equity compensation given that amount of information?

11. Grant Size. How much of the company are you will to give one individual? How much are you willing to give right now? What expectations does that set for the future? How frequently will you grant options?

Most importantly, as one colleague recently put it “Equity Compensation should not be a DIY project”. Get professional help with: A) philosophy and design B) Legal and compliance C) Accounting and Taxation and, probably, D) Communication and Implementation. Like many things in life, equity compensation is easy to do wrong and hard to do right.

NOTE:  I have created a matrix with a high-level list of things to think about when rolling out an equity plan. Performensation’s Equity Compensation Design and Use Matrix.http://bit.ly/dedCyu. I help companies with this on a regular basis, feel free to contact me directly. dwalter@performensation.com

Comments & Advice:
  1. Ethan Stone Ethan Stone says:

    This is a good rundown. It's worth thinking about whether angel or VC investment is part of business plan. If it is, you need to be very careful in setting up an option plan (or any kind of equity compensation) to think about how potential angel or VC investors will see it. Angels and VCs generally prefer a clean capital structure and usually want a say in how much equity compensation the company gives out, to whom and on what terms. So if angel or VC investment is a near term possibility, it's usually better to wait to finalize your equity compensation plan in conjunction with the investment.

    That said, it's definitely worth coming up with a tentative plan before you start talking to the investors. Investors will expect you to have given the topic serious thought and won't be impressed if you haven't. Also, equity compensation plans are usually a topic of negotiation in an angel or VC investment (see item 2 in this post for a discussion: http://www.foundersspace.com/fund-raising/what-are-the-top-5-things-we-should-pay-attention-to-when-negotiating-a-term-sheet-with-vcs/). So, as with any negotiation, it's a good idea to have thought through what you want before you start.

  2. Ethan,
    Thanks for the additional information. Excellent points.

  3. John Nichols says:

    In developing markets consider the local impact – value relative to other elements of reward. A retention issue / opportunity? Also whether in certain countries staff can aford to participate in HQ stock purchase plans.

  4. Andy Klemm says:

    Excellent post and comments –

    A company may also make a careful assessment of ongoing stock plan administration requirements and sources to get that done on an outsourced basis. In addition, the company might consider subscriptions for recipients to one of the option advisor newsletters and reference sources.

  5. vinny nguyen says:

    It’s a complicated topic. How do I get started? And whom I can get help?

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