Avoiding Option Grant Mistakes, Part I: the Company Edition

We advise clients and founders through company life cycle on the ways to use equity compensation to reduce cash burn and create incentives for employees, consultants and advisors to work towards long-term success. Option grants aren’t that hard, but I see many of the same mistakes again and again.

Part I below is a look at mistakes that companies make in the option process, and some suggestions to avoid them. Coming soon in Part II, I’ll discuss the mistakes I see employees and other equity recipients making when it comes to equity-related decisions.

  1. Start right: plan the pool
  2. Be ready: have a 409A valuation
  3. Move efficiently: don’t waste time between option promises and option grants & condense Board review
  4. Not just for new hires: don’t forget about equity-based tools in terminations
  1. Start right: plan the pool

Before using a stock plan for equity incentives, a company needs to have a stock plan. It’s a pretty straightforward element of a company formation process that a startup attorney can help guide you through. Many startups default to a 10% pool, and in many instances, founders focus on their existing team when they plan out equity, limiting their consideration to co-founder vesting plans. Founders should also think about the sort of help their team will need, and how quickly they will need it.

Here are a few considerations for option pool size:

  • size of founding team (solo founders will need more help, more quickly)
  • founding technical or industry experience (especially important for teams that will need significant additional peoplepower to build a minimum viable product)
  • the company’s competitive landscape within the tech/startup world (if the business plan is dependent on hiring people away from “hot” companies, expect that new hires will demand more equity)

Data from Carta shows that equity pool sizes at the time of financings tend to represent around 15% of company capitalization, but that shouldn’t necessarily dictate the equity pool size at formation because investors are strongly incentivized to have push for larger option pools prior to investment.

  1. Be ready: have a 409A valuation

It’s possible, and in many cases optimal, to issue shares of stock out of a stock plan, rather than options that can be exercised to purchase stock later. But once a company is taken on outside financing, they should plan on issuing option grants. And to do that right, that means having a 409A valuation in place. The mistake that companies often make here is being really slow in getting a 409A valuation prepared failing to have a current valuation ready. Having a current 409A valuation on-hand is the difference between option preparation, review, Board approval and issuance taking days or taking weeks or months. Each element of the drafting cycle has a time cost and a dollar cost. The company CEO usually bears the burden of the time cost (you surely have better things to do), and the dollar cost of delay manifests itself in higher legal bills (far more efficient if your legal team complete your project in one swoop). Carta’s 409A-as-a-subscription lets companies essentially have constantly-refreshed 409A valuations, but many Carta subscribers let their old valuations expire, don’t request valuation updates that they are already paying for, or don’t prioritize responding to valuation team questions. Carta’s remaining competition for 409A has become more efficient than it used to be, and can also help get valuations completed, too.

  1. Move efficiently: don’t waste time between option promises and option grants & condense Board review

The equity conversation with new hires starts with an offer letter, pre-hire. The offer letter usually sets forth the number of options to-be issued. But that’s just a promise. An offer letter almost always has “subject to Board approval” language next to it, and that’s not just there for show. The next step in the process, post-hire, is to actually get that option granted. In addition to requiring a 409A valuation, the Board needs to review and approve the options. That’s where delays and legal cost overruns regularly pop up. There’s a fine balancing act between having the Board approving options every time there is a new hire (disrespectful of the Board’s time) and waiting until new hires are up in arms because months have passed since the time the options were promised in the offer letter. And Board approval of “high level” plans isn’t sufficient: the approval needs to have enough detail to not only issue the grants, but also ensure that future investors and acquirers can easily review diligence materials and understand what the Board approved, and when.

Worst practices:

  • multiple people get hired, and company does multiple Board approvals, and legal team does multiple sets of work
  • CEO waits until Board meeting to tell Board about new hires, and then the Board burns precious time reviewing and then talking about the details
  • Board approves options informally, and need a second cycle to approve details

Best practices:

  • Company builds up a few new grants and combines them into a single approval for the Board
  • Board is looped in on the hiring plan, so option grant approval requests are not surprises
  • Board is provided option grant information in writing (unanimous written consent) or in advance of an in-person meeting. Proposed grants contain key details (full legal name, share number, type of option, vesting schedule, vesting commencement date, state of residence, employee vs contractor) so that the Board only needs to consent once
  1. Not just for new hires: don’t forget about equity-based tools in terminations

Startups almost always talk about options and equity compensation as a way to incentivize new hires. But there are also circumstances where options can be used as a tool in connection with employee or consultant separations. In many cases, options can be modified with Board consent to create useful separation-related compensation, or as a way to maintain goodwill with departing team members. It’s a mistake to think that severance separation payments only need to be in cold, hard cash. Here are a few tools that companies can consider:

  • Vesting acceleration. I’ve seen clients opt to partially accelerate vesting.
  • Extended exercise period. In most cases, options must be exercised within three months of separation or termination. Some companies, especially in the highly competitive Silicon Valley talent market, offer extended exercise periods as a matter of policy. But being able to offer an extended exercise period as an exception is a valuable tool. It has also emerged as a generous parting incentive for coronavirus-related layoffs: at a time when personal budgets are tighter, it’s generous to give terminated workers a longer window to pay cash to the company to exercise.
  • Additional grants in connection with establishing a consulting or advisory role going forward

Changes to existing, outstanding option grants can have tax implications, and in some cases may require adjusting the exercise price, so it’s critical to talk through the possibilities with your lawyer before putting a plan in place.

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