Equity Compensation for Startup Employees: Top Mistakes to Avoid

Equity Compensation

Equity compensation is a great recruiting and employee retention tool for startups and early stage companies. You might even say it is a critical tool.

And it isn’t that difficult to deploy. However, there are a lot of rules you have to follow to do this correctly (federal and state securities laws; corporate law; tax law, etc.).

From a public policy point of view, many of these rules ought to be revisited and re-imagined. And in fact, the SEC’s Advisory Committee on Small and Emerging Company has suggested a number of improvements. If you are interested in learning more about this, I recommend giving this a read: Recommendation Regarding Securities Act Rule 701 (PDF).

Regardless of whether the current rules are well thought out or not, for today, for better or for worse, we have to live with them.

Equity compensation mistakes made by a company can be costly. They can result in the delay or death of a financing or M&A deal. You don’t want a deal upset because you weren’t aware of or didn’t follow some rules along the way.

We have put together the following list of the most common equity compensation mistakes we see in startups, so you can avoid them.

Failure to Obtain and/or Document Board Approval

If your company is set up as a corporation, then your Board of Directors has to approve all stock option grants. You will need your Board and want (for ease of compliance) your shareholders to also approve your stock option or equity incentive plan.

Board approval of all option grants is a requirement of corporate law. If the Board doesn’t approve the stock option grants, either via consent or at a duly called meeting at which a quorum was present, and which was properly minuted, then the options haven’t been validly awarded for corporate law purposes.

This can become a problem when the option price goes up, and you have batches of old options at lower prices that were never properly approved. Don’t let this happen to you. There is really no excuse to make this mistake.

If you are working with a good law firm, your attorney can prepare a Board Consent approving the option grants, make sure that it is properly executed, and add it to the company’s minute book. It’s really as simple as drafting a basic document and having all board members execute it via DocuSign.

Failing to Follow Federal Rule 701

Before you can grant stock options, you have to identify a securities law exemption for issuing the options. The federal exemption designed for this is Rule 701.

Rule 701 exempts offers and sales of a company’s securities under written compensatory benefit plans or written compensation contracts. Rule 701 has a variety of requirements. In general, if you are in charge of administering your company’s equity incentive plans, we would encourage you to read and become familiar with Rule 701. The SEC has also published Compliance and Disclosure Interpretations on Rule 701.

Rule 701 Has Mathematical Limitations on How Much Equity You Can Share

It may sound nonsensical, but Rule 701 has a rolling 12-month limitation on the amount of equity you can actually share with your employees and service providers. There are three measurements of the limit, and you get to use the one that results in the greatest measure — still imposing a limit seems like a bad idea in general, but, again, these are the rules that we have to live with for the time being.

The three limitations are: (i) $1,000,000; (ii) 15% of total assets, measured at the most recent balance sheet date (if no older than its last fiscal year end); or (iii) 15% of the outstanding securities being offered and sold in reliance on this section, measured at the most recent balance sheet date (if no older than the last fiscal year end).

For more information on these limitations, see: Rule 701 Math: The 15% of Shares Test

You need to stay within Rule 701’s limits unless you can rely on another exemption (such as Rule 506). Before each batch of option grants are made, you should do your Rule 701 math to make sure you are within these limitations.

Rule 701 also has a prospectus delivery requirement if you grant more than $10 million in any 12-Month period.

Repricing options outside of Rule 701’s mathematical limitations

Unfortunately, Rule 701’s mathematical limitations also apply to the repricing of your company’s options (typically to a lower price at the new current fair market value). If for any reason you choose to reprice options already issued, be absolutely sure that such repricing is within Rule 701’s mathematical limitations. If you intend to reprice every option grant ever issued, this will likely be an issue.

You Cannot Grant Options to Entities under Rule 701

Under Rule 701, you can grant options to employees (individuals), and consultants (provided that they are natural persons — meaning individuals). This is one of the most common mistakes we see. Rule 701, prohibits granting options to non-individuals.

For example, if a consultant, independent contractor, or advisor says that they want their options titled in the name of their LLC, you have to say no, I cannot do that. You can grant options to non-individuals but you have to grant them outside of your stock option plan, but you will have to find a different exemption then (maybe Rule 506 works).

Failure to Follow State Law

When you are granting stock options, not only do you need to comply with the federal law, you also have to comply with state law. If you are not familiar, in the compensatory equity context, federal law does not preempt state securities law. You have to comply with both. By applicable state law, we mean including the law of the jurisdiction where your optionees are resident.

For example, if you are a Washington headquartered company and you are granting stock options to California residents, you have to comply with California law. Make sure you check the law of the state in which your optionees are resident to make sure you comply with that state’s laws. Sometimes you will have to file a Notice of Stock Option with the resident state. Which leads me to my next point.

Failure to File Blue Sky Filings

Some states require that you file a form and pay a fee in their state before you grant stock options. Don’t miss these filings. Sure, they are pesky, and annoying, but the are part of the fabric of the law in this area.

Failing to Withhold Income and Employment Taxes on the Exercise of an In-the-Money Non-qualified Stock Options

If you award an employee a non-qualified stock option, if there is a spread on the exercise, the company has to withhold income and employment taxes on the spread. It is not enough to merely collect the exercise price. In this context, some employers make the mistake of thinking that because someone is no longer a former employee, they don’t have to withhold. That is a costly error. If the option was granted to an employee, you have to withhold if there is gain on the exercise, even if the optionee is no longer an employee.

Failing to Report ISO Exercises to the IRS and the Employee

If you have an employee exercise an ISO during the year, by January 31st of the following year you have to give the employee and file with the IRS Form 3921. Forget to do this at your own peril.

Misunderstanding the Tax Rules

If you don’t do it right, you can cause your equity award recipient to owe taxes on illiquid shares, and in general cause your worker to be sorry about entering into the arrangement in the first place. You are trying to incentivize, so it is important that you structure your awards in such a way that they do not cause the award recipient to regret it from a tax point of view.

Administrative Errors

Expensive and time-consuming mistakes happen often when companies self-administer their stock option or equity incentive plans. In addition to missing things like Blue Sky filings, or running over 701 limitations, we frequently see clerical errors that need to be fixed; the cost of fixing them is greater than what it would have cost to do the job right in the first place.

Frequently, companies will make mistakes such as re-titling their option plan from, say, the 2014 Stock Option Plan, to the 2015 plan for options granted in 2015. This is of course wrong. The reason we title option plans with the year of adoption is so that you remember the year and are reminded of it when you are calculating the year the plan terminates, which is ten years after the plan was adopted.

Other mistakes include improperly filling out the notices of grant, misunderstanding the meaning of terms like date of grant, etc. The point is that it pays to spend some time and money to carefully and correctly administer these plans the first time around, rather than having to pay someone to go back in time, diagnose the problem, and then fix it.

These are the top equity compensation mistakes to avoid that we can think of at the moment. We’ll update this list as we come across more. In the meantime, make sure to avoid these equity compensation mistakes at all costs.

Enjoyed this post? Subscribe to our newsletter to get latest stories delivered to your inbox.