Startup options are among the most common and important form of compensation for startups. An option is a contract that allows the grantee to purchase the shares of a company at a fixed price (Exercise price) in the future. Typically the grantee is given the right to exercise their options over a 10 year period or within 3 months of ending their employment/advisory relationship with the company. There’s also a vesting period that details how many options get vested over time during the term of the option.
While most people are familiar with options at a high level, there are many aspects of options that you should understand as a founder before you start granting options to employees, advisors and board members
ISOs vs NSOs
There are two different types of options — Incentive Stock Option (ISOs) and Non-Qualified Stock options. ISOs can be granted only to employees and have better tax treatment compared to NSOs. NSOs should be granted to advisors and board members though some startups grant NSOs to employees as well — for example, Microsoft granted NSOs to employees in the early days.
With ISOs, grantees are liable for AMT tax treatment for the difference between the FMV (Fair Market Value) of the common shares and the exercise price when they exercise their options. Thereafter, when you sell your shares you are eligible for capital gains treatment if you sell your shares at least 2 years after they were granted and 1 year after they were exercised. You can find more details regarding ISO tax treatment over here. I, therefore, recommend that early employees exercise their shares as soon they vest (as long as you are bullish about the prospects of the company) since the cost can be low and you can significantly reduce your tax burden.
NSO gains are treated as ordinary income at the time of exercise. Subsequently, when the stock is sold, the gain between share price at the time of exercise and the time of sale is treated as capital gains. You can find more details for NSO tax treatment over here.
Vesting for employee stock options typically takes place over 4 years with 25% vesting after 1 year and monthly vesting thereafter. Vesting for advisors is typically monthly for the period of time that you have hired the advisor. The Founder Institute offers a standard template for an Advisor agreement as well as guidelines on much equity to offer to advisors.
409A Valuation of Shares
Before granting options, you need to get approval for the option grant from your company’s board which should then be recorded in the board meeting minutes. To avoid IRS penalties, the exercise price for the grant should be set to be the same or above the FMV (fair market value) of the company’s common shares on that date. However, the FMV of the common shares cannot be an arbitrary number that you or your board determine. Section 409A of IRS code requires that the company conduct an independent valuation of the company’s share price. Typically this is done by hiring a third-party accounting firm. The cost of the valuation can be anywhere between $5,000 to $15,000. You should ideally have a 409A valuation done right after a financing event since your share price will have changed at that point. The 409A valuation should be done before any new options are granted to establish a safe harbor.
409A valuations are valid for a maximum of twelve months after the valuation date or until a material event. A material event is an event that could reasonably be expected to affect a company’s stock price. For most early-stage startups, a qualified financing is the most common type of material event.
Establishing an Option Pool
Most investors will require you to establish an option pool that is between 15 to 20% of your fully diluted number of shares so you can grant options to employees and advisors without further dilution. It is important that you create an option pool budget for the options that you plan to grant over the next 12 to 18 months that is approved by the board. This will ensure that you have enough options to cover your hiring plans during that period. You should also record all your option grants in a spreadsheet or utilize a tool like Carta.
Options are a valuable form of incentive you can offer to employees to invest their heart and soul into the company. Typically, the first stock grant is the biggest option grant that employees receive upon joining a company. However, make sure to periodically grant additional smaller grants to keep your employees motivated and to ensure that they remain with the company for a long period of time.
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