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What is the standard protocol for granting equity compensation?

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By November 7, 2024No Comments

Equity compensation – such as stock options or grants of restricted stock[1] – can be a valuable tool for startups trying to attract and retain top talent. To avoid costly penalties and potential hiccups during fundraising diligence, it is crucial to understand the rules governing the grant of equity compensation and follow proper governance protocols when making such grants.

Following the steps outlined below when granting equity compensation will help you avoid the common equity grant pitfalls discussed later in this post.

Step 1: Determine Grant Information. While the company is the sponsor of its equity incentive plan, the company’s board of directors, or a subcommittee thereof, is typically named as the “Plan Administrator” responsible for administering the plan. The Plan Administrator’s duties should be set forth in the equity plan, but, in general, the Plan Administrator will determine who will receive an equity award, the type of award (option, restricted stock, etc.), the size of the award, the vesting terms the award will be subject to, and the situations (if any) under which the award’s vesting may be accelerated.

Keeping track of these variables is important, so we suggest creating a chart like the sample below. It will come in handy when documenting the board’s approval of the grants (see Step 3 below).

Name; Residence Job Title Type of Award Size of Award Exercise Price Grant Date Vesting Commencement Date Vesting Schedule Acceleration terms (if any)
John Doe

Chicago, IL

VP of Sales ISO 10,000 $0.14 October 1, 2024 January 1, 2024 A No acceleration
Jane Smith

Chicago, IL

Consultant NSO 8,000 $0.14 October 1, 2024 June 30, 2024 B No acceleration
Vesting Schedule A: 4-year vesting schedule; 25% vests on the first anniversary of the Vesting Commencement Date; the remainder vests monthly on the last day of each month
Vesting Schedule B: 2-year vesting schedule; 12.5% vests on the last day of each calendar quarter

 

Step 2: Determine the Company’s Per-Share Price. Whether you’re granting options or restricted stock, you’ll need to determine the price per share of the company’s stock to set the exercise price of any options or to calculate the value of restricted stock granted to a recipient. To comply with the legal requirements governing incentive stock options (“ISOs”) and to ensure nonqualified stock options (“NSOs”) are exempt from the restrictions imposed on deferred compensation by Section 409A of the Internal Revenue Code, the exercise price of options should, in most cases, be set at no less than the fair market value (“FMV”) of a share of the company’s common stock on the option’s date of grant.

While there are various methods for determining FMV for this purpose, the most defensible method is for the company to engage a third-party, independent appraiser to complete a valuation of the company (a “409A Valuation”). Once a 409A Valuation has been completed, the Plan Administrator can use the per-share price of the company determined by the 409A Valuation to set the exercise price or value of the company’s equity grants.

Step 3: Approve the Valuation and Authorize the Awards. After the appraiser completes the 409A Valuation and the Plan Administrator has used it to (tentatively) set the exercise price (for option grants) or issue price (for restricted stock grants), the company’s governing body (typically the board of directors) should then: (a) approve the 409A Valuation, (b) confirm that no material events have occurred since the valuation date used by the 409A Valuation that could reasonably be viewed as materially affecting the FMV of the company’s stock, and (C) authorize the grant issuances. The board can accomplish this via action by written consent or by adopting board resolutions approving the equity grants during a meeting of the board. If the Plan Administrator has created a chart as recommended above, this can easily be attached as an exhibit to the written consent or included in the materials distributed to directors for an in‑person meeting.

Step 4: Execute Grant Agreements and Update Cap Table. After the board has authorized the awards, the Plan Administrator can start documenting the grants. Some companies choose to complete this task via a cap table management platform, while others prefer to collect signatures on their own form of “Option Award Agreement” or “Restricted Stock Award Agreement.” Either way, the company’s capitalization table should be updated following the issuance of all grants to be sure that (a) each award recipient appears as a stakeholder on the company’s cap table and (b) the size of the available equity pool is decreased accordingly.

Step 5: Complete Securities Filings. Some states, like California, require companies to make securities filings in connection with grants of equity compensation, while others do not. Consult your legal counsel to confirm what filings, if any, may need to be made.

Common Pitfalls:

When granting equity compensation to your employees and consultants, be wary of these common pitfalls:

  1. Inadequate Pool Size: Double-check the size of the available equity pool when determining grant sizes. If the equity pool is too small to accommodate the planned grants, the equity incentive plan will need to be amended. If you intend to issue ISOs, both the company’s board and its shareholders will need to approve the expansion of the equity pool. Depending on how much common stock a company is authorized to issue as equity compensation (and how much remains to be issued), an amendment to the company’s certificate of incorporation or articles of incorporation may also be required.
  2. “Stale” 409A Valuation: A 409A Valuation is generally valid for 12 months from the valuation date. However, if the company experiences certain material events during that period, the 409A Valuation can no longer be relied upon. Before issuing new equity awards, confirm that the 409A Valuation isn’t stale—either due to being more than 12 months old or because of the occurrence of material events. For more on this topic, please see our What is a 409A valuation? Guidepost.
  3. ISO $100K Rule: If you are issuing ISOs, consider the total value of each grant that will vest each year. If an ISO recipient will vest in more than $100,000 of ISOs (determined using the exercise price of the option) in a year, any options exceeding that amount will be treated as NSOs instead. For more on this topic, please see Unlocking the Power of Equity-Based Incentive Compensation: An Overview of Equity-Based Compensation Alternatives.
  4. ISO 10% Owner Rule: When granting ISOs to recipients who hold 10% or more of the company’s equity, remember that the exercise price of those ISOs must be at least 110% of the FMV. In addition, unlike ISO awards for non-10% owners (who may hold ISOs for up to 10 years), ISOs awarded to a 10% owner cannot have a term of more than 5 years. For more on this topic, please see Unlocking the Power of Equity-Based Incentive Compensation: An Overview of Equity-Based Compensation Alternatives.
  5. Appropriate Authorizations: Confirm who must approve each issuance of equity compensation. Sometimes, the company’s board of directors has the sole authority to approve each issuance. However, if a company has completed a preferred stock financing round, the preferred stock investors may also have certain approval rights—either by virtue of the protective provisions in the certificate or articles of incorporation or as a result of provisions in an investment document, like an investors’ rights agreement or a side letter. Determining who has the authority to issue equity compensation may become an issue (a) when granting awards to certain officers (CEO, CTO, etc.), (b) when deviating from the company’s “standard” vesting schedule, or (c) when an amendment to the certificate or articles of incorporation is required to accommodate an increase to the size of the equity incentive pool.
  6. Types of Awards: Carefully consider what type of equity award each recipient will receive (i.e., options (and, if so, ISO or NSO), restricted stock, etc.)—and be sure to confirm that the recipient is actually eligible to receive such award. For more information on various types of awards, please see our What are stock options? and What’s the difference between an ISO and an NSO Guideposts and Unlocking the Power of Equity-Based Incentive Compensation: An Overview of Equity-Based Compensation Alternatives.

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[1] Although this post discusses the procedures and pitfalls applicable to grants of corporate restricted stock and stock options, the guidance provided is generally applicable to membership interests in LLCs and other non-stock entities. There are, however, certain differences between grants issued by corporations and those issued by LLCs and other partnership-type entities. Before issuing equity incentives to employees of LLCs or similar entities, discuss any proposed grant with your legal counsel.

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