Most startup founders have at some point in their careers been the beneficiaries of stock option grants. However, many need a primer in order to structure an appropriate plan for their directors, advisors, employees and consultants. Having the right tools can help you structure an effective stock-based incentive plan for your team.
A stock option is a right to buy a share at a particular price on specific terms. Startups use stock options to provide an incentive to directors, advisors, employees and consultants. If the value of the company increases above the exercise price (that is, the price at which the option shares can be purchased), the option holder benefits. Using this tool tends to make option holders think and act like quasi-owners of the business and aligns their objectives with those of the shareholders. Stock options are typically subject to vesting conditions; in other words, the holder earns the right to exercise the option by remaining employed or engaged as a consultant by the company at regular intervals (monthly, quarterly) over a fixed period of time (usually three or four years).
Start-ups use restricted stock grants for the same purposes as stock options. With restricted stock grants, beneficiaries receive the shares up front, usually for no or nominal cost. The shares are made subject to “reverse vesting” agreements that enable the corporation to repurchase the shares at nominal cost if the individual ceases to be employed with the company. As with stock options, this “reverse vesting” period usually covers three or four years. Corporations often obtain voting trust agreements so they can maintain control over any voting rights attached to these shares.
Founders should create a budget for stock incentives that complements the startup’s future human resources requirements. Most external investors fully expect that up to 15 to 20% of the company’s common equity will be allocated or available for such incentives. In order to determine an individual’s entitlement in a startup, seek peer input regarding comparable equity grants to similar roles in comparative companies. Avoid expressing an option grant as a rolling percentage of the startup—this causes all sorts of problems if the company plans to issue additional equity to other stakeholders (including external investors).
Founders decide on the right vesting schedule. The general rule of thumb is three or four years for employees and consultants, but startups should feel free to tailor these requirements in order to get the most from their participants. By and large, stock grants for board members and advisors are less likely to be subject to long-term vesting criteria, and very early-stage companies often adopt shorter or milestone-based vesting schedules in order to incent their teams to hit short-term objectives.
Identifying the tax implications for team members involves a complex process. Keeping in mind the massive amount of technical information in this regard and that you should consult a tax advisor before implementing your strategy, it’s worth knowing that the tax treatment of option grants are largely determined by two key questions:
If the answer to both of these questions is “yes”, then the tax treatment for employees and consultants is very manageable. If the answer to either of these questions is “no”, then founders should seek input from a legal or tax advisor to help them explain the financial consequences for the affected individuals.
The board of directors of your company has the power to grant options. Typically, companies use one of the following two methods of setting stock option terms. The first is to enter into a one-off agreement with each option holder to lay out the terms of the option (for example, amount, exercise price, expiry and exercise terms). The second and by far the most common approach is to adopt a stock option plan and grant options subject to the terms of that plan. The stock option plan forms a standing contract to which option holders must agree in order to receive options.
This article was produced by James Smith and Shane MacLean and is made available through the generosity of Labarge Weinstein Professional Corporation.