Five Common Mistakes US Companies Make When Issuing Stock Options to US Service Providers

With special thanks to Jacob Hanna and Blake Martell for their contributions.

Issuing option grants to incentivize employees, consultants and advisers is a near universal practice for start-up companies in the US, but there are a number of mistakes that are easy to make and can create legal and tax issues that can be difficult and costly to fix after-the-fact (if they even can be fixed).  Knowing some of these common pitfalls and working with your legal counsel before granting options can save you a lot of time, expense and heartache.

US companies will want to avoid these five common pitfalls when issuing stock options to service providers in the US:

1. Mistakenly believing that the company has granted a stock option, when it has only promised to grant one

A promise to grant an option in an offer letter, employment agreement, or a consulting agreement, even if signed by the company, does not actually grant a stock option, though it may give rise to a claim by the employee or consultant. Granting an option requires the formal approval of your company’s Board of Directors, either at a formal Board meeting or by a written consent signed by all of the members of the Board.

These formal requirements for option grants to US taxpayers can have an economic impact on the company and the optionees because of the US tax requirements around option exercise prices. To avoid certain negative US tax consequences, the stock option will need to have an exercise price that is equal to or greater than the fair market value, or FMV, of the shares on the date that the option is granted. So by the time you realize that the option was not actually granted, the FMV of the common stock may have increased significantly, and the option grant recipient may end up with a higher exercise price than they would have had if the option had been approved at the proper time (the Board cannot date the option grant approval as of the date that the company had intended, but failed, to make the grant). As a result, the recipient will miss out on the potential benefit of any gain in value of the common stock during that period of time.

To avoid this situation, you should contact legal counsel once you decide to promise stock options so you can establish a regular cadence (often quarterly or monthly) for obtaining Board approval of options for anyone who has actually started working for the company. This is especially important for early-stage companies that might not have a regular schedule of Board meetings, and for companies that are considering new fundraising.

2. Forgetting to include any special terms in the Board approval

Relatedly, acceleration of vesting (e.g., “double-trigger” acceleration) and other special terms need to be specifically approved by your company’s Board when it approves the option grant. It is not sufficient to simply reference these terms in an offer letter or consulting agreement; the Board needs to approve the acceleration or other similar special terms, ideally in connection with the approval of the option grant itself. Make sure your counsel is aware of any special terms you have promised to employees or other service providers regarding their option grants (and consider consulting your counsel in advance of promising such special terms in writing so they can help you avoid any foot-faults or inconsistencies with these special terms) – it will save questions and hassle (i.e., time and money) later.

3. Making stock option grants to persons or entities that are not eligible to receive a grant under the terms of the equity incentive plan

You may want to grant options to future or former employees, to service providers that are contracted through a professional employer organization, or PEO, or to entities instead of individuals (e.g., a consultant that provides services through an LLC). However, your company’s equity incentive plan or option plan may prohibit making option grants to these recipients. If you grant options that aren’t permitted under your equity incentive plan, you can create unintended securities law compliance and tax issues that can also complicate a future financing or sale of the company. 

One eligibility requirement that is generally universal to US option recipients is that the option recipient must be a current service provider on the date of grant.  In other words, the Board cannot approve a stock option for someone who has not yet started working for the company, or someone who is no longer providing services.

Other eligibility requirements may be unique to your equity incentive plan and will require review and confirmation by your legal counsel prior to proceeding with the grant. For example, your equity incentive plan may prohibit option grants to (1) LLCs or other entities rather than individuals, or (2) indirect service providers who are providing services to the company through a PEO. 

4. Violating the “ISO” rules

Some options, known as incentive stock options, or ISOs, qualify for favorable treatment under the US tax code. Many option grants issued to employees who are US taxpayers can be eligible for ISO treatment so long as the requirements are satisfied.

While there are a number of requirements for ISOs (see this Cooley GO article for more detail), one common mistake that companies make is to overlook the special requirements that apply when the ISO recipient owns more than 10% of the total combined voting power of all classes of company stock at the time the option is granted.  For option grants to these 10% stockholders to qualify as ISOs:

• The exercise price must be at least 110% of the FMV at the time of grant, whereas most other options have an exercise price equal to the FMV at the time of grant.
• The option term must be five years or less from the date of grant, as opposed to the 10-year term that is typical under most equity incentive plans.

The ISO requirements also limit the number of options that will be eligible to qualify as ISOs based on the value of the options (measured as of the date of grant) that become exercisable in any given calendar year. Companies can trip this threshold with large option grants or with option grants that are early exercisable (see this Cooley GO article for more detail).

To avoid missing out on ISO treatment for option grants that might otherwise be eligible, check with your counsel about the basic ISO requirements, and confirm option terms with your attorneys before having grants approved, especially in the case of (1) option grants to founders or other major stockholders, (2) large option grants, and (3) options that are early exercisable.

5. Ignoring US federal and state securities laws

A stock option is a type of security under US law, which means that you will need to comply with federal and state securities laws. Give your legal counsel advance notice of any proposed option grants, including the optionees’ states of residency, number of shares subject to the option grants, and the current FMV of the shares,  so they can review federal and applicable state securities law requirements and advise you appropriately ahead of the Board’s approval of the option grants.

What about US companies granting options to service providers outside of the US? 

Another common pitfall to be avoided is making grants to non-US residents without taking local advice. Legal requirements, tax consequences, and compensation practices regarding options vary greatly among countries. Even modest option grants to employees or contractors in any jurisdiction can trigger tax withholding or securities filing requirements for the company, and unexpected tax requirements for the option recipient. If you are planning to hire employees or engage contractors outside of the US, talk with your legal counsel in advance about engaging local counsel to get ahead of these matters. Make sure to consult your tax and/or accounting advisors regarding these option grants as well.

Related Articles – Establishing the Ownership Culture: Stock vs. Options