Avoid these common pitfalls when granting stock options

Stock options are an integral part of almost every startup or early-stage company. Stock options are a great tool to recruit and retain employees, and align the interests of the company and employees.

There are some mistakes that companies make when granting options. These can impact their next deal or financing round and disincentivize the employees they were trying to help.

1. Inability to obtain board approval

Let's begin with an obvious one founders often overlook in the beginning: Stock option grants must first be approved by board.

The stock options will not be granted if the board does not approve the request (either at a meeting of the board or by unanimous written consent). If the company attempts to correct this oversight, which is often after the company's value has increased, they are forced to give the options at a higher current value than the one the employee was supposed.

It is not a good idea to inform employees that they won't share in the company's increased value because they didn't follow corporate formalities. This problem can be easily avoided by creating a standard board consent you use every time an option is granted. Your board members can even approve via email

2. Fair market value is not granted

Remember that option grants must have an exercise price equal to the grant date, which is usually the date the board approves. The IRS will impose a 20% penalty tax on income if the grants are less than fair market value. Some states, most notably Califo ia, impose an additional penalty tax.

It can be difficult to determine the fair market value for common stock in the early stages of a private company because they are not publicly traded. Don't use the last round of fundraising valuation as a proxy for fair value. Many financings are made up of convertible notes and preferred stock classes. The fundraise valuation might not reflect the fair value of common stock given under employee option plans.

Although it can be costly for early-stage companies, it is worth hiring an outside firm to assess the fair market value. This valuation will be in accordance with Section 409A (also known as a "409A appraisal"). This report has the advantage that it transfers the burden to IRS to prove that the option price was not fair market value, if ever it is challenged. The company must prove that the option price was fair market value without this report. This is usually done at a time when it has the benefit of hindsight.

3. Refusing to renew the valuation report

Once you have received your 409A valuation, keep in mind that it is not valid forever. You must get a new 409A appraisal at least once every twelve months, according to IRS regulations. You will also need to renew your 409A appraisal if there is a "material modification" in the company, such as a termsheet for a new financing round or acquisition. If the company is planning a major deal or fundraise, it may be necessary to suspend stock options until the transaction is completed. You can also obtain a new valuation report that takes into consideration the changes in circumstances. Failure to comply with Section 409A can result in severe tax consequences for your employees.

4. Inability to comply with securities law

Many new businesses don't realize that the federal securities law prohibits the sale of securities to the public. Rule 701 allows private companies to offer stock options as part of an employee stock option plan. However, certain mathematical limitations must be met in order to avoid being exempted from registration.

In particular, the maximum sales price of any shares or shares sold under Rule 701 during any 12-month period cannot exceed (i) $1,000,000; (ii), 15% of the issuer's total assets; and (iii) 15% of the outstanding securities of the class. Additional disclosure requirements will be triggered if the total sales price of shares sold under Rule 701 exceeds $10,000,000 in a 12-month period.

Google was famously found guilty of violating Rule 701 when it issued options that were greater than the limits during its IPO years. The SEC issued a public cease-and-desist order against Google and its general counsel one year after the IPO. This is clearly not a good outcome for a publicly traded company.

Don't forget to check local securities laws. Califo ia is one example of a state that requires filings and payment of fees in order to grant options to residents. Companies must also ensure that they comply with non-U.S. securities laws when making equity grants.

5. Stock options are not for everyone

Rule 701 states that stock option plans can only be granted to natural persons. This is often the case when a consultant renders services to the company. They ask to have their options titled under the name of their LLC.

Although it is usually okay to grant stock options under an option plan to individual consultants, grants cannot be granted to entities. Consult your atto ey if you wish to grant options to other individuals. These options may not be available under your stock option plan. You will need to register separately.

Understanding the rules surrounding option grants can be a problem early in a company's life. This is often before dedicated counsel is available to assist with these issues. You can avoid costly errors that could impact your company and employees by being alert to potential mistakes early.