Equity compensation mistakes cause financial, tax, and regulatory hardships and can result in disputes between employers and employees. As with most things in law and business, doing things right the first time means building more and fixing less.
Here are ten common equity plan mistakes to avoid. Disclaimer: this is not legal advice.
1. Promising Stock Options in an LLC. Founders of companies formed as LLCs often incorrectly promise current or future employees "stock options." LLCs do not issue stock options. LLC ownership interests are generally called member units or simply units. There are big differences between corporate stock and LLC units, and hence big differences between stock options and instruments that might sometimes be issued as "unit options."
Creating an equity incentive plan for an LLC is far more complicated than for a corporation. Read chapters 6 and 7 of my book Startup Law and Fundraising for more on these issues and how to decide between an LLC or a corporation for a new business.
Founders of startups formed as LLCs should make no promises of equity ownership to employees before consulting with competent tax counsel.
2. Granting Stock Options with No 409A Valuation Report. Stock options must be granted with an exercise price equal to "fair market value," or "FMV." Tax consequences for recipients of "discounted" options can be severe. These include being taxed as the options vest instead of when they are exercised and paying a 20% tax penalty on top of ordinary income tax rates.
Any "Incentive Stock Option," or "ISO," granted at less than FMV is also automatically converted to a less tax-favorable "Non-Statutory Option," or "NSO." NSOs are also called "Non-Qualified Options" because they do not meet ISO statutory requirements. We discuss ISOs and NSOs below.
Further, the FMV of every single stock option grant must be supported by a 409A "valuation report." This "409A," as they are commonly called, must be "current," or "fresh," meaning no older than 12 months, but also no older than the latest material corporate development. In general, six months is safe, absent a material development. Getting a 409A valuation report takes between three and eight weeks. Plan accordingly to avoid granting delays.
Issuing options with an outdated or missing 409A report is an error that can complicate, delay, and even threaten financings and exit opportunities. 409A mistakes will become a focus in any financial audit and can also become due diligence holdups in any material financing or M&A transaction.
In Startup Law and Fundraising, I write about how legal and regulatory issues can be mentally plotted on a "likelihood and materiality" matrix to aid in prioritizing their prevention or correction. This focuses attention on two issues - how likely is it a particular mistake will turn into a problem and, if so, how material would it be.
For a promising, high-growth startup, 409A non-compliance is highly likely to be discovered because 409A is on every audit and due diligence checklist. When discovered, substantial 409A non-compliance is likely to feel like a 7 or 8 on a 10-point pain scale. This is because of the significant potential tax penalties for employers and employees and the uncertainties those create from the perspective of auditors and parties in due diligence. 409A non-compliance is the type of issue that deal counsel for potential acquirers play up to lower a target company's valuation and/or to increase financial holdbacks and escrows in a potential M&A deal.
Some of the most mind-numbing literature on earth can be found by searching online for "correcting 409A compliance failures." Potential 409A scofflaws might do well to peruse some of these readings.
3. Promising Options but Not Granting Them. Employers often promise options in offer letters but then fail to follow through. Option grants must be approved by the board and fully documented. Grant recipients must sign an option agreement and often an option grant notice detailing the option terms.
A purported option grant not approved by a board of directors is NOT an option grant. It is a dispute waiting to happen. Approving option grants without certain key terms can also invalidate them - terms such as exercise price, vesting schedule, number of underlying shares, and duration of the option.
Frequently, by the time a delayed option grant is belatedly approved and documented, the company's FMV has increased and, thus, so has the option recipient's exercise price. This directly reduces the option's value. Thus, failure to timely follow through on option grants can financially harm employees, creating risks of a breach of contract claims against the company.
As noted, sometimes boards approve grants but then managers drop the ball documenting them. If board approval is sufficiently clear and well-documented, later completing option documentation is only modestly risky.
If the board approval is poorly documented or otherwise deficient, attempting to later document and "paper over" defective option grants raises tax, accounting, and regulatory risks.
For publicly traded companies, one of these risks is a potential SEC charge of "options backdating" under the Sarbanes-Oxley Act of 2002. The Stock Option Backdating Scandal of 2006 to 2011 involved SEC investigations of 150 companies, resignations and terminations of numerous general counsels, and federal prosecutions of a dozen corporate officers, with at least five receiving prison sentences.
4. Promising Changes to Grants without Approval or Documentation. Once options have been granted, amending their terms requires documented board approval. Two terms that option recipients sometimes seek to change are (i) acceleration of vesting upon a change of control and (ii) extension of the time the employee has to exercise options after termination of employment. Officers sometimes agree to these changes to retain valuable employees but then fail to obtain board approval and document the amendments.
M&A deal announcements often flush out one or more employees claiming either written or orally promised rights to accelerated vesting that are not detailed in any board resolutions. Those issues can usually be resolved, albeit with some difficulty.
On the other hand, when an employee has left a company and his or her options are canceled after the time provided in the grant but contrary to an actual or alleged promise to extend, it is generally impossible to revive those canceled options. Expect a thorny dispute when significant, well-priced options are canceled contrary to a written promise that their post-termination exercise ("PTE") period would be extended.
5. Inadvertently Converting ISOs to NSOs. In the preceding example, we discussed PTE extensions. As mentioned earlier, ISOs and NSOs have different tax attributes, with ISO tax treatment being more favorable for employees. Perhaps most importantly, holders of ISOs pay no income tax upon exercise, while holders of NSOs pay ordinary income tax (including federal, state, Social Security, and Medicare) on the exercise of any option to the extent FMV exceeds the exercise price.
When stock issued from the exercise of an ISO is held longer than a year after exercise and longer than two years from the grant date, the gain or loss on the sale or other disposition of those shares will be long-term capital gain or loss. Under ideal conditions, therefore, ISO holders can avoid paying ordinary income and payroll tax rates on their options, which are generally more than double long-term capital gains tax rates.
One of the key requirements for ISO status, in addition to shareholder approval of the equity compensation plan itself, is that the option must be exercised within 90 days of the employee's termination of employment.
Options can be granted as ISOs with the stated right to exercise after the 90-day post-termination period, but any ISO exercised more than 90 days after employment termination converts to an NSO.
It is also possible to amend an existing ISO to extend an option's PTE, but this must be done with care. If a board unilaterally extends an option's PTE, this converts the ISO to an NSO. One can easily imagine option holders harmed by that unilateral action making a claim against the company for any out-of-pocket taxes.
To avoid this, the board should approve extending the PTE, but subject to (i) the option holder's written agreement and (ii) disclosure to the option holder that they should obtain tax advice before agreeing to the resulting ISO-to-NSO conversion.
Option holders who would not want to extend their PTE beyond 90 days are those who (i) can afford to pay the exercise price, (ii) are relatively confident that paying the exercise price will be a wise investment, and (iii) want to avoid paying income and payroll taxes on the exercise, including any immediately-due withholding taxes. On the other hand, option holders who need more time to accumulate funds to pay their exercise price are more likely to want to extend their PTE, despite the tax disadvantages of doing so.
The extension of PTEs for longer than 90 days is appealing from a recruitment and retention perspective and laudable from a moral perspective, but it also results in (i) substantially increased accounting and administrative burdens on the company, (ii) reduced stock available for issuance to future employees, and (iii) increased "dead equity" on the company's cap table - i.e., stock held by persons no longer contributing to the company's success.
It is also worth noting that NSOs allow companies to deduct compensation expense and are less burdensome from an accounting perspective than ISOs. A board's decision whether to grant ISOs or NSOs should be made with a clear understanding of the pros and cons of each for the company and its employees.
6. Failing to Timely Process Option Exercises. When an employee takes the required steps to exercise an option, the company is obligated to timely complete the exercise process and issue the shares, whether those shares are issued physically or electronically.
Failing to process a properly submitted election to exercise for so long that the option is canceled per its PTE is messy. This is probably the one situation in which it is legally permissible to "uncancel" an option. Once an optionee has completed their option exercise paperwork or platform-based exercise processes, the company is generally obligated to process the exercise and has no discretion to reject it. If the option incorrectly cancels during that period due to the company's administrative lapses, that cancelation is arguably an unauthorized, improper, and reversible transaction.
Depending on the circumstances, though, others could later assert that the issuances under the canceled option were invalid. This could raise issues impacting the company's cap table, accounting, and financial reporting, and the option holder's rights.
7. Granting Options that Exceed Reserved Shares. All options must be issued pursuant to a board-approved equity compensation plan. And all equity compensation plans require that the board "reserve" a number of shares of stock available for issuance under the plan. It is also worth noting that the number of reserved shares must not exceed the number of authorized and unissued shares under the corporation's certificate of incorporation.
Sometimes companies set up equity compensation plans and, over a few years, inadvertently issue more options than the approved number of shares reserved for issuance under the plan.
Any ISOs granted in excess of reserved shares, or worse yet, in excess of authorized shares under the certificate of incorporation, would seem to be invalid under 26 U.S. Code § 422. Section 422 requires ISOs to be "granted pursuant to a plan which includes the aggregate number of shares which may be issued...."
Whether or not NSOs granted in excess of reserved or authorized shares can be rehabilitated is an issue about which experienced counsel may have differing views. If the options cannot be rehabilitated and if favorable exercise pricing is therefore lost, presumably the impacted option holders would need to be made whole one way or another at the company's expense.
Aside from potential disputes and accounting issues, auditors would flag such over-issuance mistakes as evidence of weak internal processes and controls. Potential investors and acquirers might even be the ones who discover the error in due diligence, possibly leading to greater scrutiny and skepticism.
8. Failing to Track Employee Terminations and Vesting. Even when using Carta, Capshare, or another cap table platform, a company must timely input employee terminations to ensure that option vesting stops and PTE periods are properly calculated and observed.
Here is a scenario that plays out once in a while: (i) a company fails to enter an employee's termination date in Carta or Capshare, (ii) the option holder's options continue to vest erroneously, (iii) the option holder then exercises the options, including the erroneously vested options, and then (iv) the company has to repurchase the improperly issued shares when they are discovered in an audit or due diligence.
This series of mistakes causes tax, accounting, financial reporting, and cap table accuracy issues. Avoid these headaches errors by using a robust cap table platform and by adopting employee exit processes that include systematically entering employee terminations within the platform on a same-day basis.
9. Tripping Over SEC Rule 701. All issuances of securities must be either (i) registered with the SEC or (ii) exempt from registration. Exemptions are not easy to come by for issuances to non-accredited investors. The exemption for equity compensation grants is SEC Rule 701. As Google found out, blowing the Rule 701 exemption is a great way to make headlines with the SEC.
Rule 701 is easy to comply with for startups that keep grants within certain limits. All grants must be made under a written, board-approved equity compensation plan and, during any 12-month period, the total value of option grants by exercise price cannot exceed the greatest of: (i) $1 million, (ii) 15% of the company's total assets, or (iii) 15% of the outstanding shares of the class of equity being offered under the rule.
If necessary, grants to accredited investor senior officers can be taken out of these calculations, since they should qualify for the Rule 506(b) exemption.
Rule 701 also has disclosure requirements. As long as the total value of option grants in a twelve-month period is less than $10M, the company simply has to give its optionees a copy of the equity compensation plan. If grants exceed more than $10M in a twelve-month period, the company must provide "enhanced disclosures" under Rule 701: (i) a statement of risk factors, (ii) two years of financial statements and year-to-date financials if the year-end financials 180+ days old, and (iii) a "summary" of the equity compensation plan.
Both the basic Rule 701 disclosures and the enhanced disclosures must be provided to option holders well in advance of exercising their options and to grantees of restricted stock awards at the time of grant.
Strangely, once the $10M threshold has been exceeded, the enhanced disclosure requirements are applied retroactively for the entire 12-month period. Companies must anticipate when their equity grants will exceed $10M and comply with the enhanced disclosure requirements for the 12 months leading up to such time. This disconcerting retroactivity was codified by the SEC in 1999 and has been later reaffirmed, as in this "Answer" in the SEC Division of Corporation Finance's Compliance and Disclosure Interpretations (issued before the $5M threshold was increased to $10M):
Answer: The Rule 701(e) disclosure must be provided to all investors in the Rule 701 offering if the issuer believes that sales will exceed the $5 million threshold in the coming 12-month period, not only to those who purchase securities after the issuer exceeds the $5 million threshold. As stated in Securities Act Release No. 7645 (Feb. 25, 1999):
“This requirement will obligate issuers to provide disclosure to all investors if the issuer believes that sales will exceed the $5 million threshold in the coming 12-month period. If the disclosure has not been provided to all investors before sale, the issuer will lose the exemption for the entire offering when sales exceed the $5 million threshold.” [Jan. 26, 2009]
10. Granting Taxable Restricted Stock Instead of Tax-Deferred RSUs. Non-publicly-traded corporations generally have two alternatives for equity compensation: (i) stock options and (ii) restricted stock. Each has its pros and cons.
For a founder or significant early team member, for example, getting a large restricted stock grant early in a startup's existence when its FMV is low can be very advantageous. Most restricted stock awards are subject to a risk of forfeiture akin to stock option vesting, but in reverse. Commonly, in year one, the entire restricted stock grant would be forfeited if the employee leaves the company. This risk of forfeiture is often reduced 25% each year over four years.
When a restricted stock award involving low-FMV shares is subject to risk of forfeiture, the grantee is permitted under the tax code to pay all of the income tax upfront by filing a Form 83(b) with the IRS within 30 days of the grant. This locks in all income tax obligations at a low level (because of the low FMV) and also starts the holding period for the shares immediately, which can dramatically reduce future capital gains taxes under Section 1202 of the U.S. tax code.
But large restricted stock grants by high FMV startups can result in bad tax consequences. Ordinary income and payroll taxes are due as the risks of forfeiture expire. If the value of the company is rising steadily, so will the taxes due at each stage of forfeiture expiration. And the shares cannot generally be sold to cover those taxes - they come out of the grantee's pocket. Additionally, taxes paid on restricted stock grants are not refundable if the company fails and the stock becomes worthless.
When the FMV of shares to be awarded is substantial, these risks can be avoided by awarding "restricted stock units," or "RSUs," instead of plain "restricted stock."
RSUs are a little more like options, except without any exercise price. While the holder of restricted stock is actually a shareholder of the granting company, RSU holders have only a contractual right to receive their stock upon the completion of certain conditions.
RSU conditions are often two-fold to limit adverse tax effects: (i) expiration of the risks of forfeiture relating to continued employment and (ii) closing of a liquidity event (sale or IPO) and any other defined conditions (like a six-month underwriter lock-up) upon which the shares are or can be converted entirely or in part into cash. Holders of RSUs structured this way will never be taxed unless and until they have money to pay the taxes.
THE CASE FOR AUTOMATION
Platforms like Carta and Capshare are critical for competently administering equity compensation plans. Mistakes are likely even with these platforms, but they are generally fewer and less severe. Both Carta and Capshare provide 409A valuation services and facilitate all other aspects of equity plan administration and compliance, including:
presenting required disclosures to optionees,
obtaining optionee signatures on option documentation,
providing optionees the ability to see and track their grants, vesting, and equity ownership information,
accurately tracking and accruing option vesting per grant documents,
providing easy and transparent means of exercising options and other awards and preserving records of those exercise transactions,
terminating vesting of departing employees, and
as PTE periods expire for departed employees, canceling their options and forfeiting those shares back into the plan pool so they can be granted again.
Experienced investors also like to see their companies using these platforms for the cap table confidence and transparency they provide.
SUMMARY
Treat equity grants seriously. Correcting mistakes can be difficult, expensive, and uncertain.
Don't over-promise. Offer letters should say no more about equity grants than something like "... and we will recommend to the board that you be granted options for ### shares of company stock on our standard terms."
Obtain and maintain a current 409A valuation report from the moment an option plan is proposed and through the life of the equity plan. While critical for grants, current 409A's are also important for processing tax collections and remittances for NSO exercises.
As employees are on-boarded, timely present their promised option grants for board approval, complete the required option paperwork, and enter the grants in Carta, Capshare, or another reputable platform.
Avoid promising changes to existing option grants when possible and make sure any such promised changes are timely presented for board approval and are properly documented.
Understand the differences between ISOs and NSOs and be thoughtful whenever changing the PTEs of existing ISO grants. There are tax and accounting implications and option holder consent must be obtained.
Well before option holders might be expected to exercise their options, make sure accounting and payroll systems are in place to process those exercises and the associated collection of exercise payments and taxes.
Timely process all option exercise requests.
Be mindful of the limits and requirements of SEC Rule 701, including the retroactivity of Rule 701's enhanced disclosure requirements and the need to look ahead 12 months at all times.
Know the differences between restricted stock and restricted stock units and select wisely between the two to avoid bad tax consequences for employees.
Equity compensation plans and grants are serious business. Mistakes and lax administration cause unpleasant tax, accounting, legal and regulatory headaches. Work closely with competent tax, legal, accounting, and equity administration professionals to stay out of trouble. And as always, build more and fix less.
Paul Swegle has served as general counsel to numerous tech companies and advises a dozen others as outside counsel. He has completed $12+ billion of financings and M&A deals, including growing and selling startups to public companies ING, Capital One, Nortek, and Abbott.
Paul has authored two authoritative and practical business law books, available for preview and purchase here: