Designing a Stock Option Plan for Startups

Employees who join early-stage startups are taking on a considerable risk given the low job security. At the same time, their contributions are vital for the survival and scaling up of the startups. To compensate for the risks and the importance of their contributions, early-stage startups commonly offer stock options to their employees.

However, offering excessive stock options can lead to significant dilution. This is why board approvals are necessary for granting such compensation. Instead of looking for approvals every time, it is better to design a plan that is in line with your hiring and retention needs and then seek board approval.

In this article, we will guide you in stock option planning. We will discuss the different types of equity-based compensation you can issue, how to identify your stock option pool size, how to maintain tax compliance, and how to maintain the option pool.

What kinds of equity compensation can you issue?

In this section, we will go over some equity compensation that is commonly granted to employees. This should help you choose the best-suited equity interest for each employee.

Stock options

Stock options give employees the right to purchase a fixed number of their startup’s shares at a specified price called the exercise price. Typically, this gets vested over a certain period and some companies allow early exercise.

The two types of stock options are as follows:

Restricted stock units (RSUs) and awards

Employees must fulfill certain performance and time-based requirements before their restricted stock units (RSUs) get vested. Upon vesting, typically, RSUs get awarded without any need for employees to pay a purchase price. RSUs are taxed as ordinary income when they vest.

RSAs are subject to time-based vesting conditions only and allow employees to buy shares at a discount. At the time of grant, if the exercise price is less than the fair market value (FMV) of the shares, employees will owe tax on the difference between the two.

On the sale of RSAs, whether the employee pays ordinary income tax or long-term capital gains tax depends on their holding period after exercise.

With RSAs, employees can start their clock early for long-term capital gains treatment through 83(b) elections.

Performance-based stock

These options are paid to employees when certain organization-level performance metrics are met. Once the shares are delivered, the employees will need to pay tax on the FMV of the shares. Any capital gains on sale are taxed as per the employee’s holding period, just like RSAs.

Employee stock purchase plans (ESPPs)

ESPPs allow employees who have been with the company for a certain amount of time and have less than 5% of company shares to purchase company shares at a discount of 5% to 15%.

In a qualified ESPP, all participants must have equal rights, the offering period cannot be more than 3 years, and there are some restrictions on the maximum price discount. In contrast, such requirements do not apply to non-qualified ESPPs which do not have the same tax benefits. Qualified ESPPs require shareholder approval.

Phantom stocks

This gives employees the benefits of shares (dividends and capital gains) without actually giving them the shares. So, a phantom stockholder has no voting rights. Payouts from this are deductible for companies. Capital gains tax treatment is not available for since the payments are made directly in cash and there is no grant of equity.

Now, let us see how different equity compensation can be used:

How much equity should be given to whom?

You must design a stock option plan that aligns with your hiring needs. To do so, you must take the following steps:

• Create a hiring plan until the next funding stage – Start by forecasting future headcount requirements until the next funding round. While you do so, identify any critical hires you need to make.
• Identify vacancies – You may not need to offer stock options for all roles. You must consider the dilution impact to make sure you are offering equity only for positions critical to your growth or when absolutely necessary.
• Identify the right type of equity interest for each role – Not all roles may warrant equity compensation that comes with voting rights. Junior to mid-level employees may prefer phantom stocks over performance-based stocks since they may not need voting rights and their actions do not directly impact company-level performance metrics.
• Find out the market standard equity compensation – You can hire the services of a human resources agency to identify the industry standard equity compensation for each role. This will help you make competitive offers and ensure that your option pool is of appropriate size.
• Consider the role of equity in retaining talent – Even if you need not offer equity for certain junior-level roles, you may need to offer equity to retain them in the future if they show potential. Additionally, you may need to offer equity to retain senior management. So, you may need to adjust vesting schedules to ensure key employees stay at your company.

By following these steps, you can identify the appropriate size of your startup’s option pool and the types of equity compensation you may need to offer.

Board approval for stock option plans

Once you have identified your stock option pool requirements, you must create a document that lists all types of equity compensation you plan to issue, the amount of equity you plan on offering, vesting schedules, exercise prices, terms for departing employees, and performance-related conditions.

Then, you must share this document with your board of directors to get their approval. When you do so, you must provide dilution analysis for various scenarios. Needless to say, you will also need to accurately communicate the necessity of offering stock compensation.

How to make your stock option plan tax-compliant?

A key part of designing stock option plans is ensuring tax compliance. Here, the taxable income is typically calculated on the difference between the exercise price and the equity compensation’s fair market value (FMV). The FMV is the product of a 409A valuation, a business valuation compliant with Section 409A of the Internal Revenue Code (IRC).

A 409A valuation is considered valid for 12 months or until a material event like acquisition, sale of company assets or divisions, or significant secondary share sale happens.

If you do not get a 409A valuation when you issue equity compensation, your employees may have to pay a tax penalty, and higher interest rates on unpaid taxes, and their immediately taxable income may also increase.

Of the various 409A valuation methods, hiring an independent valuation expert like Eqvista is the best course of action. This can be quite cost-effective as you can get unlimited 409A valuations for an annual subscription. Also, hiring an independent valuation expert ensures that your internal team can focus on tasks critical to your startup’s growth.

How to extend offers?

When you extend equity offers to potential hires, you must have a clear communication strategy. You need to explain the value of stock options in monetary terms and the vesting conditions. If the potential hires are not familiar, you must clarify key concepts like vesting periods, exercise prices, potential for capital gains, and tax treatment.

You could use examples to demonstrate how your company’s share price could increase in the future and offer capital gains to the employees. You should also compare the tax treatment of long-term capital gains versus ordinary income for high-income levels.

Transparent and clear communication about the benefits and risks will help the potential hires make their decisions.

How to maintain a stock option pool?

The size of stock option pools must change when:

• The option pool is underutilized
• The stock options are exercised or expired
• Your hiring plan changes

If you can attract and retain employees by offering less equity than initially forecasted, your option pool will be underutilized. In such cases, you can reduce the size of your option pool.

When employees exercise stock options, you must make the appropriate reduction in the pool size and list the employees on your cap table. When options expire without being exercised, you should again reduce the size of your employee stock option pool.

Such adjustments will ensure that your cap table provides clear insights into possible dilution scenarios.

Also, you must periodically review your option documents to ensure that you are complying with all the relevant tax laws and regulations.

Craft Tax-Compliant Stock Option Plans with Eqvista!

Before you set out to design a stock option plan for your startup, you must understand the key differences in various types of equity compensation. You must understand the differences in voting power and tax treatment.

Then, you must forecast the required headcount up till your next funding round. While you do this, you must identify the right equity compensation for each role. You should also identify if you want to use equity for retaining employees.

After you have compiled your option plan, you must get board approval. You should invest in a 409A valuation annual subscription plan like the one offered by Eqvista to stay tax-compliant.

Periodically, you must adjust the option pool size for exercises, under-utilization, expiry, and changes in hiring plans. You must also review your stock option plan from a legal perspective.

At Eqvista, in addition to 409A valuations, we also offer equity and tax advisory services to help companies issue equity without worrying about tax penalties. Contact us to know more!