Implementing a stock option plan for your company
By Chase Irwin and Sean Del Giallo
A stock option plan is a beneficial way to incentivize employees, contractors and other stakeholders in the success of your company. By holding options to purchase shares of the company that vest over time, participants in a stock option or equity incentive plan can obtain a degree of ownership in the company itself. Granting options also provides additional compensation to employees and stakeholders, and can be an attractive feature of an overall compensation package to potential and existing workers. Implementing a stock option plan can be an important component of compensation to incentivize employees and contractors working with you in those early days, particularly when there may not be much, if any, cash flow.
The basic premise of a stock option plan is that stock options are granted at a certain exercise price and can be exercised according to the terms of the plan. Ideally, as the company grows, the participant will be exercising their option and purchasing shares at a price lower than the value of those shares on the date they exercise their options.
A set pool of a specific non-voting class or series of shares is usually created when setting up a stock option plan. Options are then granted out of a reserved pool of shares to avoid ongoing dilutive effects to existing shareholders. Typically, a standard stock option pool is between 10 percent and 20 percent of the company’s capitalization, though this number may vary according to a given company’s specific hiring plans. For example, in a financing round, an investor might require that an option pool represent a certain percentage of the company capitalization either prior to or following the closing of the financing, and this should be negotiated and set out in the term sheet.
Options are always granted subject to the terms of the stock option plan itself and documented in a separate option agreement between the company and the participant. The option agreement sets out specific terms, including the terms and conditions of the option, the number and class of shares subject to the option, the exercise price for the option shares, and the date when vesting commences.
This vesting period is an important feature of an option to help incentivize participants and ensure participants have demonstrated commitment to the company by the time their options are “in the money” (i.e. their options have vested and can be exercisable for shares). Most options will be subject to a standard period of vesting for each participant in a plan. The market standard for a vesting schedule is currently three or four years, where a portion of the options will vest and become exercisable on the one-year anniversary of the date the option was granted. The remainder will then vest at the end of each month over the remaining vesting period. This vesting period tracks with the stay of a committed employee at the company. As a result, if the employee is terminated or resigns, their options stop vesting at that point. Any vested options earned up until the point the employee leaves the company should be addressed in your stock option plan.
Vesting can also be customized on a case-by-case basis and may be tied to certain milestones rather than over a period of time. For example, some startups may engage a sales representative or marketing agent on a contractor basis, and rather than granting options to vest over a period of time, may tie the vesting of options to the delivery of qualified sales leads or other measurable criteria.
When considering a stock option plan or granting options, you should always consult your legal counsel. Your legal team should have established templates for stock option plans and can help you create a plan in a cost-effective manner. As you continue to grant options to employees and stakeholders, your counsel will help you maintain proper records, which is important for good corporate governance and for due diligence on any future financing rounds or exits.