To issue compensatory stock options to employees, contractors, or other service providers, a company should first adopt a written compensatory benefit plan, which is required for a corporation to comply with certain tax and securities laws. This type of plan is commonly known as an “equity incentive plan,” a “stock incentive plan,” or more simply, a “stock plan.”
Assuming that the company has a valid equity incentive plan and enough shares reserved and available for issuance under the plan, then each time the company wishes to issue or grant new stock options, its board of directors must formally approve the terms of the option grants, including the price at which the stock option may be exercised (known as the “exercise price” or the “strike price”). For tax reasons, the exercise price generally should be equal to or greater than the fair market value of the underlying stock at the time of grant. To safely determine the fair market value, many companies will obtain an appraisal of their stock, known as a 409A valuation, from an independent, third-party valuation expert.
In addition to the exercise price, a company will generally need to specify the following terms for each stock option grant:
- The name of the stock option recipient
- The recipient’s state or country of residence (for compliance with securities laws)
- The number of shares for which the stock option may be exercised
- Designation of the stock option as an ISO or an NSO
- The stock option’s vesting schedule and the date on which vesting will commence
- Acceleration, early exercise, or any other features of the stock option, if applicable
For legal due diligence purposes, the approval by the board of directors of any option grants should be documented in writing (i.e., by unanimous written consent, or minutes of a board meeting). Once the board of directors has approved any stock option grants, the company will prepare and distribute stock option paperwork to the option recipients to document their new stock options. Alternatively, many companies now use online cap table management platforms to manage stock option grants and their associated documentation electronically. Notice that an offer letter promising a stock option grant is not, in and of itself, a stock option grant. All equity-related matters of a corporation, such as stock option grants, must be approved by the corporation’s board of directors and properly documented in order to withstand scrutiny in future due diligence (e.g., during a financing or an acquisition of the company).
Stock options involve the intersection of tax, employment, contract, and securities laws and can be surprisingly complicated. There are many tools now available to assist with the mechanical process of granting stock options, but there are still many traps for the unwary that could result in unintended legal or tax consequences. A company should consult with its attorneys and tax advisors prior to granting options to obtain up-to-date advice.