Founder’s Guide to Setting Up an Employee Stock Option Plan
An employee stock option (ESO) plan is an important part of any startup’s compensation plan. ESOs provide employees with a financial incentive to participate in a company’s growth and success, and many startups wouldn’t be able to attract and retain employees without an employee stock option plan. To help founders develop a plan, we’ve provided a step-by-step guide.
This employee stock option plan guide is intended for founders of funded companies who are looking to bring on a team that will be excited about stock options. This is not intended to be a beginner’s guide; it is intended for founders of technology startups who are looking to set up employee stock option plans for their employees.
As a CPA Firm that serves hundreds of startups, we often work with founders just after they have secured their first round of financing. We’ll go through the steps to set up a plan. And we’ll highlight some of the issues we commonly see (and try to help fix) that first time founders make when offering options.
Perhaps the most common mistake we see is poor recordkeeping – if you promise options to an employee, you need to keep track of the number of shares, vesting schedule, and other important details. Storing this information in emails is not enough!
How to Set Up an Employee Stock Option Plan - ESO
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Determine the total number of shares to be offered to employees and set aside a portion of the company’s total shares for the stock option plan - consider using our free stock option sizing model.
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Choose the type of options. The two types of options include incentive stock options (ISO) and non-qualified stock options (NSO). Read more below on each type.
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Establish a vesting schedule that specifies when employees can exercise their options.
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If needed, establish an advisor vesting schedule for advisors or consultants who aren’t employees.
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Create a stock option agreement (also called a stock option offer letter), which is a contract that explains the terms and conditions of the stock grants. Have your law firm draft up a templated one that you can use as you hire.
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Establish the strike price through a 409A valuation.
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Get board of directors approval for the plan.
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Create an option agreement that outlines the terms and conditions of the employee stock option plan.
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Keep accurate records with a capitalization table.
What are ESOs?
An employee stock option plan is a kind of employee benefit plan. With an ESO, employers actually offer the option to purchase stock in the company, rather than giving stock shares directly. The employee has the right to buy company stock at a specified price (the exercise or strike price) for a fixed period of time. If the company’s stock price climbs above the exercise price, then the employee can buy the stock at a discount. The employee can then sell the stock for a profit or hold onto it. The checklist above gives an overview of how to establish a stock option plan, but let’s look at all the steps in detail.
How Do Startups Offer Stock Options?
Setting up an ESO is going to require some time and effort upfront. You don’t want any difficulties or regulatory violations to derail your plan. We want to emphasize that creating a stock option plan should be done with the involvement and experienced startup attorney and your accountants, since mistakes can create significant legal and tax exposure. So start off right:
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Plan ahead
Your first step is planning. What crucial hires is your startup going to need over the next 12 to 24 months? Start by solidifying your recruiting and hiring plan, and remember to consider when you’ll seek your next round of funding.
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Manage your equity.
Each time you raise funding, you’ll issue new shares to investors, and you’ll probably increase the size of your employee equity pool for additional hires. It’s a good idea to review your remaining equity pool each year, and determine how much you need to add to it. Your board and stockholders will need to approve each increase. Most startups manage their equity pool like a budget, holding some back for bigger hires that may be needed later.
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Set some guidelines for stock options.
Once you know how many people you’ll need, estimate a high and low equity range for each role. You don’t want to award stock options on a case-by-case basis. Remember that more senior and technical hires are typically in high demand, so you’ll need to issue larger option grants for those roles. Do some research on competitive salary and equity packages. Your board of directors, other founders, and VC investors can be a valuable resource for this information. As part of your formalized equity plan, you should think about promotions and performance, so the employees have a bigger equity stake as their responsibilities increase.
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Get a 409A valuation
To issue stock options, founders should get a 409A valuation before issuing any options. A 409A valuation is an independent evaluation of the fair market value (FMV) of a startup’s common stock. You’ll hire an outside firm to review your startup’s financials and market data to determine your stock’s value.
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Use the 409A to set the strike price
Each employee option grant that you issue will have an exercise (or strike) price that’s the FMV of the common stock on the date the grant is approved by your board of directors. If the employee is issued more options at a later date, the new options will have their own exercise price, set on the date the options are approved by the board.
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Adopt your vesting and cliff schedule.
We cover vesting schedules in more detail below, but make sure your vesting schedule works with your startup’s time horizons. A startup with a long-term focus might over six- or even ten-year vesting.
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Set an expiration timeline
Typically ESOs have an expiration date (see the vesting schedule section below for more information). But what happens when an employee leaves the company? Many companies set the expiration date for departing employees at three months after the employee leaves. ISOs are required to expire three months after an employee departure, so many companies do the same with NSOs. It’s possible to provide a more extended timeline for NSOs, but it increases the company’s administrative burden. Some startups feel it isn’t fair to force employees to make a decision about their options that quickly. You’ll need to choose the timeline that fits your company’s values.
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Create an ESO agreement and get your board’s approval
This is the legal agreement your employees will be signing to accept your employee stock option offer. You’ll find more information about the specific sections of the agreement below.
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Track all equity, preferably using capitalization software
The capitalization table shows every investor’s equity stake in your startup. An accurate cap table is important for many reasons, including fundraising, investor due diligence, and dilution of your ownership percentage.
Those steps provide an overview of the general process of creating an ESO, but let’s look at some of the steps in greater detail.
Where Do a Startup’s Stock Shares Come From?
Founders need to appreciate that the option pool dilutes the founder’s initial ownership. Imagine a startup that is 100% owned by the founder – like many startups in the idea phase. Say an engineer decides to join the company shortly after. However, when this new engineer gets shares in the company, it dilutes the founder’s equity.
The company can’t have 110% share ownership, so if the new engineer gets 10% of the company through an option plan or through founder shares, the original founder now only effectively owns 90% of the business.
Technically where do the option pool shares come from?
When a company is incorporated, it is set up with a set number of shares. This is an important decision that happens when a founder decides to incorporate a startup. How many stock shares should you start with? You’ll need enough for any founders, enough for the employee stock option pool, and enough for future employees and investors. You’ll need to specify a number of authorized shares as part of your startup’s articles of incorporation.
Generally speaking, most startups registering as Delaware C-Corps start with 10 million shares of common stock. Eventually some investors will need preferred shares (which have special rights), but starting out, you only need to authorize common shares. Why 10 million shares instead of 1 million, or 1,000, or even 100?
For one thing, numbers that are divisible by 10 are easier to work with. But more importantly, smaller stock pools mean that each share has a much greater ownership stake in the company. Delaware law states that you can’t issue fractional shares, and it’s difficult to give employees more granular stakes in the company if you’re starting with a low number of shares. As startups grow, they typically provide new employees with smaller stock grants.
Not all of the authorized shares should be allocated or issued to founders. A portion needs to be allocated to the employee stock option pool. There aren’t any hard and fast rules about how many shares should be allocated to the ESO plan, but generally, around 20 percent of the total shares authorized is reserved for the ESO pool.
Types of Stock Options
There are two types of options that founders can choose from:
- Incentive stock options (ISO). Sometimes ISOs are called qualified or statutory stock options. ISOs are typically offered only to company executives and top employees, and are issued on a beginning or grant date. ISOs have tax benefits for employees, but they are also subject to certain restrictions. ISOs require a vesting period of at least two years and a holding period of more than one year before they can be sold. These employees can buy company shares at a discounted price, and if they wait at least two years to sell those shares, they’ll be taxed at the long-term capital gains rate instead of short-term rates, which can represent a huge tax savings.
- Non-qualified stock options (NSO). Sometimes called non-statutory stock options, NSOs do not have the same restrictions as ISOs, but they are not eligible for the same tax benefits. NSOs are available to employees, as well as investors, board directors, partners, advisors, consultants, and even vendors. NSOs don’t receive the same favorable tax treatment. When the option holder exercises the options, the difference between the exercise price and the fair market value (FMV) is taxed at regular income tax rates. In addition, NSOs are also taxed again if the option holder sells the company shares, which means NSOs have a higher tax burden.
Since both types of options have tax implications, you’ll need to report employees that exercise options to the IRS and issue those employees a tax form.
ESO Vesting Schedules
If you’re using an employee stock option plan to recruit employees, you obviously don’t want to hand them their options on the first day of their employment. They wouldn’t have any reason to stick around! That’s why most stock option plans have vesting schedules, where the employee earns the options over time.
In addition, as mentioned above, the ESO is only valid for a finite amount of time (the exercise period). So the plan may state that the employee must exercise the options within 10 years, for example, or the options will expire.
Typically, companies offer a four-year vesting schedule with a one-year cliff. This means that the employee doesn’t earn any stock options for one year, and then it will take four years of employment for the employee to become fully vested. The employee’s first anniversary with the company is called the cliff date, and that’s when the employee receives the first chunk of stock options. All the terms of the plan must be fully spelled out for the employee in an employee stock options agreement.
Let’s look at a simple example. Your startup offers an employee 1,000 stock options on a four-year vesting schedule at a rate of 25% per year with a one-year cliff, and the ESO expires after 10 years. .
- The employee accepts the option agreement, which is now the grant date.
- One year after the grant date, the employee is vested in 25% of the 1,000 stock options, or 250 stock options. The employee could exercise the options at this point, and purchase 250 shares of stock, or simply let the options accumulate.
- Each subsequent year, the employee is vested in an additional 25% of the stock options (250 each year). Again, the employee could exercise the options in chunks as they vest, or let them accumulate.
- Four years from the grant date, the employee is fully vested, and can exercise 100% of the stock options (1,000 options).
Advisor or Consultant Vesting
As we noted above, non-qualified stock options (NSOs) can be issued to other people that aren’t employees, including advisors and consultants. Startup founders often wonder how to structure these options, since these types of engagements are typically short-term.
- Vesting. Advisor grants typically vest monthly without a cliff. The vesting period is typically 24, 36, or 48 months, depending on how long the advisor/consultant is working for the startup. Many advisors are on a two-year schedule, since they tend to have expertise that applies during a specific company stage, and once the company moves past this stage, they don’t tend to rely on an advisor.
- Exercise period. Most startup option plans for advisors require that the vested options be exercised within three months of the termination of the advisor agreement, or else they expire. That’s a requirement for incentive stock options (ISOs), not NSOs, and most startups apply the three-month exercise requirement to both types of options. For NSOs this is negotiable, and some advisors/consultants will ask for a longer exercise period. That allows the advisor more flexibility to come up with the exercise price, and prepare for the tax bill that potentially could arise at the time of exercise.
Remember, the startup ecosystem is relatively small, and one advisor may very well find out the terms that your startup offered to another advisor. It’s best to be consistent with all your advisors when setting up the advisor ESO plan.
Creating an ESO Agreement
An employee stock option agreement is a contract between a startup and its employees. Both parties must operate within any terms and conditions stipulated in the agreement. The main terms of a stock option agreement include:
- Parties to the agreement. These are typically the company issuing the stock options and the employee receiving the options.
- Amount of option shares. This is the number of shares the employee will have the right to purchase in the future.
- Exercise price. Also called the strike price, this is the price at which the employee has the right to purchase the shares, and is set at the fair market value of the company’s stock at the time of issuance.
- Total exercise price. The agreement will also note the total price that the employee pays if the employee purchases all the options.
- Effective or grant date. This is generally the day the employee signs the agreement.
- Conditions to exercise. These are any requirements that have to be met before the stock options can become effective. This is the section where companies will outline the vesting schedule.
- Expiration date. This is the amount of time the employee has to exercise the stock options, and the agreement terminates on the expiration date.
The employee stock option plan needs to be carefully thought out, but variations on the plan can be negotiated with individual employees. Formalizing a stock option plan is a very complex process, and will need to be approved by the board of directors and stockholders. It’s important to consult your attorney to make sure that you comply with all state and federal regulations, and different states have different regulations. If you have employees in another state than where your startup is, you need to make sure you’re following the correct regulations.
Maintain Accurate Records
Any startup with an ESO plan needs to maintain and update its capitalization table each time a stock option grant is made. A cap table is a document or spreadsheet that lists all the securities that your startup has issued and who owns them, including common shares, preferred shares, warrants, convertible notes, and options, among other securities. The table needs to list the option holders, their addresses, the grant date, number of shares, the cost, the strike or exercise price, the vesting dates, and any exercise dates.
The cap table spells out the ownership structure and financial structure of a startup for founders and investors, and it helps manage your ESO program. It’s pretty easy to see that a cap table can get very complicated very quickly, with multiple types of securities and the owners of each type. While some early-stage startups initially use a spreadsheet to create a cap table, spreadsheets can be difficult to maintain, since the cap table needs to be updated when your valuation changes, when you get new investors, and when stock options are offered to employees, and reconciled annually as part of your federal and state tax requirements.
Typically we recommend using a cap table management software system such as Carta. Your lawyers will normally manage the cap table and keep it updated, and share it with your accounting team for reconciliation.
Benefits of ESOs
An employee stock option plan is a way for startup companies to attract and retain employees by offering them an opportunity to own a stake in the company and feel more invested in the business. In addition:
- Option plans can benefit startups financially, helping them make competitive offers to prospective employees without having to pay large salaries.
- Stock option plans improve employee retention, so founders and managers can focus on building the business instead of hiring employees.
Please note that this is general information about ESOs. Setting up a stock option plan is not a do-it-yourself project, and it’s very important for you to consult with with legal and financial professionals before implementing an employee stock option plan for your startup. For more information about ESOs, capitalization tables, and startup accounting, please contact us.
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