Issuing stock options? Here’s what you need to know

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

A reader asks: My co-founder and I are ready to hire a couple of key employees, and one of our advisors suggested we set-up a stock option plan and offer that as an incentive.  What is a stock option and what are some of the issues we need to worry about?

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Answer: The formal answer here is: An employee stock option is a security that gives select staffers the right to buy a certain number of shares of the company’s common stock at a predetermined price at some point in the future. The answer that might mean more to you, though, is: Options are a way to give employees an incentive to work harder to ensure the company succeeds, since as the stock price increases, their options gain value.

Because it provides employees with this opportunity to benefit directly from any gain in the company’s value, stock options are quite common in startups. From a founder’s perspective, they’re appealing since they avoid any cash outlays and align the interests of the owner and workers.

There are a few significant issues that you will need to address in connection with the issuance of employee stock options. Here’s a look at them:

Vesting Schedules.  Establish a reasonable vesting schedule in order to incentivize employees to remain with your company and to help grow its business.  The most common schedule vests an equal percentage of options every year for four years, with a one-year “cliff” (i.e., 25 percent of the options vesting after 12 months) and then monthly, quarterly or annually vesting thereafter – though monthly is the most common. (The monthly vesting schedule may help deter an employee who has decided to leave the company from staying on board for his or her next tranche.)

For senior executives, there is also generally a partial acceleration of vesting upon a triggering event (such as a change of control of the company or a termination without cause) or more commonly, two triggering events, such as a change of control followed by a termination (without cause) within 12 months.

Securities Laws.  As I have previously discussed, a company may not offer or sell its securities unless those securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable State commissions; or there is an applicable exemption from registration.

Fortunately for startups, SEC Rule 701 provides an exemption from registration for any offers and sales of securities (including stock options) made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation, provided that they meets certain prescribed conditions.  Most states have similar exemptions, including California.

It’s imperative you seek the advice of experienced counsel prior to issuing any stock options. Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the holders, injunctive relief, fines and penalties, and possible criminal prosecution.

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IRC Section 409A.  Under Section 409A of the Internal Revenue Code, a company must ensure that any stock options granted as compensation has an exercise price equal to (or greater than) the fair market value of the underlying stock as of the grant date. Otherwise, the grant will be deemed deferred compensation and the recipient will face significant adverse tax consequences. (The company will also have tax-withholding responsibilities.)

A company can establish a defensible fair market value by obtaining an independent appraisal or if it is an “illiquid start-up corporation,” relying on the valuation of a person with “significant knowledge and experience or training in performing similar valuations” (including a company director or employee), provided certain other conditions are met.

Restricted Stock.  Finally, depending upon the stage/value of your company, consider issuing restricted stock to the employees in lieu of stock options for three principal reasons:

• Restricted stock is not subject to Section 409A
• Restricted stock is arguably better at motivating employees to think and act like owners (since the employees are actually receiving shares of common stock of the company, albeit subject to vesting)
• The employees will be able to obtain capital gains treatment and the holding period begins upon the date of grant, provided the employee files an election under Section 83(b) of the Internal Revenue Code.

The downside of issuing shares of restricted stock is that upon the filing of an 83(b) election (or upon vesting, if no such election has been filed), the employee is deemed to have income equal to the then-fair-market value of the shares.

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If the shares have a high value, the employee may have significant income and perhaps no cash to pay the applicable taxes.

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.