Private companies grant stock options to their employees as a way to retain and motivate them and to reward their employees for the company’s success. Included below are five common mistakes we have come across.
- Option Exercise Price. When setting the exercise price for an option, the company should refer to the last stock valuation and evaluate whether anything has changed that would impact the stock price; such evaluation should be documented.
- As background, the exercise price for an option must equal the fair market value of the company’s stock on the grant date in order to avoid adverse tax consequences under Internal Revenue Code Section 409A and the code provisions relating to incentive stock options.
- Generally, a stock valuation established by an independent appraisal that meets certain prescribed statutory standards, and that is as of a date not more than 12 months prior to the relevant grant date, will satisfy the statutory requirements for setting the exercise price.
- We have seen companies make the following mistakes when setting an option’s exercise price: (a) the company does not consider events or information that occur after the independent appraisal, which may have an impact on the company’s stock price; (b) the company grants an option immediately prior to a new valuation (either within or outside of the 12-month period described above) with a new higher stock price valuation, which calls into question whether the appropriate exercise price was used for the option; and (c) the company does not document its process for determining the exercise price.
- Grant Date. Identifying the grant date for an option is important because the exercise price must equal the value of the stock on the grant date and for accounting reasons. In order to establish the grant date for an option, the company (through its proper delegate) must take all necessary action to grant the option and set the material terms of the award, including the number of shares (and class of stock), the exercise price, the vesting schedule, and the identity of the award recipient. We have seen options with incorrect grant dates because either (a) the person (or committee) making the grant did not have the authority to make the grant under applicable law, or (b) the award does not include all of the material terms of the option.
- Treatment of Option Post-Termination. A company should consider what the appropriate post-termination option exercise period should be, and whether it should be extended beyond more than a short period following a participant’s termination of service. We see companies that want to accelerate the vesting, or extend the post-termination exercise period, of an option that has already terminated in connection with a participant’s termination of service.
- Change in Control Treatment. The equity plan documents should include sufficient flexibility to address all potential change in control outcomes to avoid uncertainty and because it may be difficult to implement changes after a transaction has started. Some mistakes we see in equity plan documents include:
- Failure to include a unilateral right to cancel and terminate equity grants, including underwater options
- Not clearly permitting the cash-out of equity grants without participant consent
- Failure to address whether equity awards vest automatically upon the change in control, or upon termination of employment within a time period following a change in control
- Failure to address whether awards that are not assumed by the successor automatically vest
- Failure to describe how achievement of performance goals is measured and, if applicable, adjusted to reflect the change in control
- Securities and Other Compliance
- When making an equity grant, a private company must ensure that the requirements for the applicable federal and state securities exemptions are satisfied. We see companies fail to meet the federal securities requirements by, for example, not meeting the eligibility or award threshold requirements under Rule 701 (a federal securities exemption often used by private companies making equity awards), or failing to meet the state securities exemption requirements. For example, California requires that the equity plan include certain substantive requirements and that a notice be filed with the California Department of Business Oversight within a prescribed time period.
- When making equity grants outside of the United States, companies must ensure compliance with local securities and other requirements. We see companies fail to meet one or more of these compliance requirements by, for example, not addressing applicable local securities or employment rules.