In this guide, we will discuss how early-stage startups can legally structure the issuance of stock options, also referred to as share options, for their employees. Stock options serve as a great tool for motivation and retention, and can relieve early-stage startups of a major administrative burden of other financial remuneration practices. Stock options are also an important instrument used to align employees with the company's growth goals, providing an incentive to work in collaboration with each other in the same direction.
Through this guide, you'll learn how to allocate an option pool, prepare an employee stock option plan, sign option agreements with employees, and what to do when employees want to exercise their options. We'll also share the best practices involved in each stage and the common mistakes you’ll want to avoid.
- Stock options are an effective tool for motivating and retaining employees in startups.
- Before issuing options to an employee, companies must allocate an option pool and approve an employee stock option plan (ESOP).
- The stock option plan must specify the size of the option pool being reserved.
- A stock option agreement with an employee cannot exist separately from the main employment agreement (e.g., an employment contract or a contract for services).
- Companies and employees need to consider the tax implications of exercising options and, if applicable, apply for tax exemptions.
- Understanding the legal and tax implications of issuing stock options to team members located abroad is an important point for founders building companies that operate globally
What are stock options in general?
A stock option is a tool that grants the right to acquire company shares in the future (under certain conditions). It is important to understand that options are not shares themselves, but rather the right to acquire them.
Why are stock options interesting for startups?
Options are most commonly used by companies seeking to achieve a new valuation with each subsequent funding round and milestone in their development. The expected outcome is that the company's shares become increasingly valuable. The main motivation for employees who receive options is to obtain the right to purchase shares at a price that is as low as possible at the time of grant and increases over time when the options are exercised.
Therefore, early employees, such as those at Google or Facebook, became millionaires when the company reached new investment levels or went public because they received stock options that allowed them to acquire shares at a low price, which later became highly valuable. For example, an employee might receive an option for 1000 shares at a price of $100 ($0.1 per share).
At the time of exercising this option (purchasing shares under the option) or when the company goes public, those 1000 shares might have a value of, for instance, half a million dollars. Thus, employees have the opportunity to profit from the increased value of the shares (that they received stock options for) over time.
What is a stock option agreement between a startup and an employee?
A stock option agreement formalizes the employee's right to receive shares in the future and the subsequent disposal of those shares. It's a contract under which an employee is granted an option for a certain number of shares at a predetermined price. We'll talk about the details of this agreement in the following sections.
How is a startup's option pool allocated?
In order for the founder of a company to be able to issue options, they must first allocate an option pool and determine the number of shares that will be reserved for the issuance of options to employees within the option pool. Only then can the company enter into specific option agreements with employees, which will specify the number of shares granted under the option, their value, and other terms.
In general, there are two approaches to allocating an option pool:
- Allocating the option pool from authorized but unissued shares.
- Allocating the option pool through future issuance of shares.
The right approach for your business depends on where your company is registered. If it is in the US, the option pool is allocated from authorized shares. If it is a European company, the option pool sets a specific total number of shares that will be issued to option recipients in the future (upon exercise).
Let's analyze this in more detail with examples.
If we are talking about a company that is registered in the United States, and specifically in Delaware, which is the most popular state for registering venture projects, then option pools are separated from authorized shares. Let’s look at this in a practical example.
When you register your company, in your certificate of incorporation, you will declare a certain number of shares, for example, 10 million shares. Now, let’s assume that 1 million of those shares remain unissued. This means that these 1 million shares have been mentioned in the certificate of incorporation, but they do not belong to anyone. These 1 million shares, as confirmed by certain corporate documents (which we will discuss later on), are allocated to the option pool. And from this one million shares now in your option pool, you can then grant options.
If we are talking about a company registered in the United Kingdom or Estonia, all option pools are formed through the issuance of new shares. This means that the shares that you will issue for options do not actually exist yet because they have not been authorized or issued. By adopting an option plan, you anticipate that a certain number of shares (any number, without limitation from the certificate of incorporation, as in the US), which is provided for in the option pool, will be issued at some point. Through this issuance, the employee will receive shares under their option.
🌏 Looking for where to incorporate your startup? Check our guide on best practices of startup legal structuring and popular countries for incorporation.
Issuing options without previously forming an option pool is not recommended. Doing so will result in the issuance of invalid options, issued in violation of corporate procedures. Every jurisdiction will hold slightly different regulations on the issuance of share options, so we recommend that you analyze the legislation in the country where you have incorporated or plan to incorporate your company. This will enable you to fully understand the steps you need to take in order to ensure compliance with all applicable laws when issuing stock options.
We also think it’s good practice that as soon as you begin to prepare to issue options to specific employees (or if you have promised them stock options), be sure to think about allocating an option pool.
How to grant a stock option to an employee
In order for a company to grant an option to an employee, it needs to allocate an option pool in advance and approve a stock option plan. Only then can it issue the stock option to a specific employee.
Allocating an option pool is the stage where the company sets aside a certain portion of shares in its capital table, from which it will later issue options for the team.
How is an option pool allocated?
To do this, two steps are taken simultaneously:
- The Board of Directors and the General Meeting of Shareholders (if we are talking about companies registered in Delaware, the UK, or Cyprus) adopt a resolution on the allocation of the option pool. Here, there must be a decision by the corporate bodies that authorize the company's decision to allocate a certain pool of shares for options.
- The second step is approving the stock option plan immediately after allocating the pool. The option plan is an internal corporate document that approves all the rules and regulations for the issuance of options, their size, and so on. We will discuss in more detail what is usually included in option plans later.
After these two steps are completed, the option can be issued.
The issuance of each option, even though the company has already allocated a certain pool of shares for options, also requires a decision by the company's management bodies.
If we are talking about the allocation of the option pool, usually both the Board of Directors and the General Meeting of Shareholders are involved. At the stage of option issuance, usually, only the Board of Directors is sufficient, which already makes a decision to issue an option to a specific employee (unless otherwise provided by your shareholder agreement, bylaws, or the option plan itself).
💡Pro tip: if you're planning to receive investments from VC, it's always best to allocate the option pool in advance. This will protect the VC's future stake from unnecessary dilution and will be a good sign that you're thinking about motivating your key employees. As Greg Brinson, CEO of Caplinked, outlines, "Having a well-structured option pool upfront simplifies negotiations and pricing, benefiting both founders and investors".
How can you confirm the issuance of a stock option?
The issuance of an option is confirmed by the resolution of the Board of Directors. Simultaneously, the option agreement is approved, which already defines the specific terms of the option, identifies the person receiving the option, and all other conditions of the option.
Next, we will discuss what is usually defined in the option plan and what is in the option agreement.
Difference between a stock option plan (ESOP) and an option agreement
An option plan is a confidential corporate document that is internal to the company and essentially regulates the formation of an option pool and the rules for its allocation. It serves as a foundational document upon which option agreements are prepared. All option agreements refer to the option plan, as they are derived from it, and the option plan is the primary document.
Let's now discuss the key terms provided in the option plan.
Administration of the option plan
This defines who manages the option plan and has the authority to make changes, etc. In other words, how the option plan is "administered".
Size of the option pool
Regardless of whether you follow the American approach to forming an option pool, where you reserve a certain number of authorized but unissued shares, or the European approach, where you plan to issue additional shares in the future, the option plan must specify the size of the option pool you are reserving.
This may prompt a logical question: what should we do if the existing option pool is exhausted and we don't have another one?
Most option plans are approved for a specific period. There are market conditions or market standards where the startup's life cycle is divided into stages tied to investment rounds:
- The first stage is the “pre-seed” seed round, where the startup raises approximately $100,000 to $3m.
- The second stage is when the startup raises a Series A round (with an average round size of $18.7m).
- The third stage is the Series B round (with an average round size of $40m).
- Then comes the Series C round (with an average round size of $59m) and beyond, including late-stage rounds D, F, or possibly the stage of going public.
What should be the size of an option pool?
The general approach is that at each stage, the startup should have 10-15% of its shares in the option pool, but this can also vary on a case-by-case basis. This is because, with each new investment round, it is expected that the startup will hire new employees.
For startups that are 8-10 years old, if you look at their corporate history, they may have approved two, three, or even five stock option plans. Each plan provides for the allocation of a new option pool to issue options to new employees.
💡Right now, there are many online tools on the market like this one from Carta or this spreadsheet that allow founders to calculate the optimal size of the option pool given the fundraising and hiring plans.
Granting of options
This section of the option plan outlines how options are issued, such as how option agreements are signed and approved by the board of directors.
Exercise of options
This describes the process of how an option, whose owner already has the right to exercise it, is executed.
Usually, the option plan provides a procedure for employees to approach the company to convert their options into shares. This involves designating a specific month each year when general shareholder meetings are typically held, such as December or the beginning of the year, depending on when shareholders gather in one place and are ready to sign all the necessary documents. By including this provision in the option plan, it eliminates the risk of employees approaching the company every month to convert their options into shares. To prevent this, the company collects these conversion requests throughout the year. Then, during the designated month, they gather all the shareholders together, to sign the required documents. All employees who submitted requests to the in that previous period can now receive their shares.
Option agreement and its essence
An option agreement is a simpler instrument than an option plan. It is typically much shorter than an option plan and defines specific numbers for the employee who signs this option agreement.
Let's briefly go through the main terms provided in the option agreement.
Size and cost of the option
For example, an employee receives an option for 50,000 shares and commits to pay $100 for those shares when the option vesting period is over.
When the employee converts their option into shares, at that point in time (which could be in 3, 4, or 5 years), those 50,000 shares will not cost $100, but possibly $100,000 or $10 million. However, with this option agreement, the employee will receive them for $100. This is precisely the main principle of how options work.
It’s also important to note that a company valuation (specifically a 409A Valuation, which we will address in detail further on), must be conducted at a later date. Typically, in situations where options are granted within the first year of a startup’s registration, the price of the options will often be low, like in the example above. When options are granted later on, for example, after the company has begun generating profits or has successfully raised funds through fundraising rounds, a company valuation must take place. This will determine the fair market value of the company’s shares, which should then be reflected in the option agreement at the time of granting the option. It is at this moment that the price may seemingly skyrocket to thousands, or even tens of thousands, of dollars, if the option is granted at a later stage of the company’s life.
When an employee signs an option agreement, they do not immediately receive all the shares. They have a vesting period during which the option is granted to them in portions.
For example, let's imagine an employee receives a stock option for 50,000 shares.
Let's assume the vesting period for this employee is divided into five years. Proportionally, the employee will be granted 10,000 shares from their 50,000 option each year. Therefore, the employee can only be entitled to 50,000 shares after working for 5 years. If they leave before that, any unvested shares will be forfeited.
A “cliff” is applied when vesting intervals are not based on years but on months or quarters. A cliff is essentially a period of time that must pass before employees can receive their shares. This is done to prevent an employee from receiving rights to shares in the first months of employment. Typically, a cliff is introduced for the first year.
Going back to our example where we have a stock option for 50,000 shares, and the employee is anticipating that they will receive 10,000 shares in the first year. In our example, there is also quarterly vesting. This means that in the first quarter, the employee can receive 2,500 out of those 10,000 shares, another 2,500 in the second quarter, another 2,500 in the third quarter, and the remaining 2,500 in the fourth quarter. This adds up to a total of 10,000 shares. So in the first year, shares are not vested quarterly if there is a cliff, but the employee receives the full 10,000 based on the annual results. Then, in the first quarter of the second year, they receive 12,500 shares, in the second quarter they receive 15,000, and so on. By using a cliff, the business can pause the vesting to closely evaluate the employee and their performance.
Good leaver / bad leaver
There are conditions under which an employee is terminated and–depending on whether they are deemed a good or bad leaver–the employee may or may not be entitled to the accrued shares.
If an employee is a “good leaver”, it means they are leaving due to health reasons or serious personal or family circumstances. They may also leave due to relocation to a different continent that does not allow remote work. In other words, these are factors that did not harm the company. If an employee is a “good leaver”, they are entitled to receive all the shares that have vested and to which they have earned the right. Any unvested shares will be forfeited.
The situation is different for a “bad leaver”, when an employee is terminated for causing harm to the company. For example, they may join a competitor, disclose confidential information, or commit a crime that harms the company. In such cases, not only are the unvested shares forfeited, but the vested shares are forfeited too. Therefore, the employee is left with nothing. This acts as insurance for the company to prevent having a shareholder who could act against the company.
These are the typical conditions specified in an option agreement to regulate and anticipate various scenarios.
An option agreement cannot exist separately from the primary employment agreement
An important point to remember is that an option agreement cannot exist independently from the primary employment or advisory agreement. When you onboard a new team member, regardless of whether they are hired under an employment contract or a freelance/contractor agreement, the option is tied to these agreements. Why is this important?
Because the provisions regarding “good leaver” vs “bad leaver” cannot exist without the primary agreement, which will define the leaving circumstances. In other words, if the employment agreement is terminated, it automatically terminates the vesting in the option agreement. Therefore, whenever you sign an option agreement with an employee, make sure you have a primary agreement to which the option agreement is tied. This way, you will have a tool to determine the number of shares the employee deserves and whether they can expect them upon their departure from the company or team.
How does exercising a stock option work?
This might be the most interesting section for readers who are employees of startups with options and are interested in learning more about how to convert their stock option into shares.
In each option agreement, there is an appendix called the “Execution Form”.
The Execution Form is a notification that includes the employee's name and a request to the company's board of directors, stating that the employee has already received a certain number of shares under their option and has the right to receive these shares. By submitting this form, the company initiates the issuance of shares to the employee, who purchases these shares at the price specified in the option agreement.
It is important to note that the advantage of an option agreement is that when the company is already worth millions of dollars at the time of option exercise, the employee does not have to pay half a million for their 50,000 shares. They pay the price specified in the option agreement, which is usually a small amount like $50 or $100, depending on the terms.
The last step is signing the package of documents, which leads to an interesting situation from the founders' perspective. How can the founders prevent employees who became shareholders of the company from blocking voting, the sale of the company, etc.? It is understood that once a person becomes a shareholder of the company, they cannot be forced to sell their shares if they do not want to. The right to shares is absolute, just like any property right.
To avoid the risk of unwanted influence by new shareholders on the company, a shareholders' agreement is necessary. The shareholders' agreement outlines the rights and obligations of each shareholder, including additional rights for majority shareholders and reduced rights for minority shareholders, often represented by employees whose options have been exercised. In the case of options, this is implemented through a Deed of Adherence.
Deed of Adherence
This document is signed by employees when shares are issued to them under their option agreements. The Deed of Adherence is a unilateral document in which the employee agrees to adhere to the company's shareholders' agreement "as is" and accept all the conditions specified in that agreement. The shareholders' agreement usually includes various provisions that allow for avoiding situations where minority shareholders can block company transactions or decisions, and so on.
Issuance of Shares
The Share Purchase Agreement (SPA) is signed, which is the agreement through which the employee purchases the shares issued to them by the company. The employee pays the value of the shares (e.g. $50 if specified) according to their option agreement.
After that, the employee receives a share certificate confirming their ownership of a certain number of shares in the company.
This is what exercising a stock option looks like. Now let’s turn to the final matter to address: taxes.
Tax considerations for stock options
We started with the fact that the entire value of the option is in its mechanics, in the principle of how it works, according to which the employee signs an option agreement stating that he will receive a certain number of shares at a fixed price. For example, at a price of $100, at a time when these shares will cost far more than $100, much higher. And here an interesting situation arises. An option for 50,000 shares was issued to the employee, which stipulates that he must pay $100 for these shares. Four years pass, the company is already worth millions of dollars and these 50,000 shares are worth, for example, $2 million, but the employee pays only $100 for them.
What does this mean for taxes? This means that the employee had an asset, the right to which he received 4 years ago and which he is now realizing, but which has grown in value tens, possibly hundreds of times. In most countries, there is a “capital gains tax”, a tax on capital growth, which is applied by default in these situations.
To avoid this situation in venture startups, many jurisdictions have special rules called “tax exemptions”.
How do tax exemptions for employee stock options work?
An employee with an option can submit a request to the tax authorities stating that at a certain moment, they will receive an option that will most likely increase in value. The request will also note that, according to certain rules, the employee may qualify for an exemption and will not be obligated to pay certain taxes when they realize their option. Importantly, it is not only the employee’s responsibility to submit tax exemption applications—the company has a responsibility to do so too.
If employees follow these rules, and submit the necessary applications, they needn’t worry about tax authorities taking half the value of their option in the future. It is very important for each employee to personally track this. It is especially important if the employee is a tax resident in the US and the startup has an American company that is connected to the stock options. If the employee is a tax resident in the UK, then they can receive both ‘approved’ and ‘unapproved’ share options. An example of an ‘approved’ option is the Enterprise Management Incentive (EMI) scheme. This is the most common scheme that SEMs will use, as it allows the company to grant employees up to £250,000 of share options in a 3 year period. Under this scheme, an employee will not have to pay Income Tax or NICs if they purchase the shares for at least the market value on the date when the option was granted to them. Growth in share value from that grant date is subject to a 10% tax rate for up to £1m of gain and 20% beyond £1m of gain. Unapproved share schemes will be subject to tax and possibly even NIC.
It is critical to note that these exemptions are often only possible when the employee is a tax resident in the same country as the company and is employed by them. Should a team member hold the legal status of a contractor or be located in a foreign country, it is important that all tax consequences are assessed in both the country where the company is registered and the company where the team member is located. The tax exemptions we have addressed above will usually not apply in these cases.
What can employees do to make sure they stay on top of their stock option matters? At the time of issuing the option, employees should always clarify with their personal accountant or tax advisor which forms need to be submitted to the tax authorities in order to qualify for this tax exemption. It is at this point that the question of valuation is also important.
Also, it's fair to say that not all the employees exercise their options even if their value is higher than the strike price. According to the 2022 ESOP report by Carta, 46% of such employees haven't exercised their options before their expiration in 2022. 23% of those who didn't exercise did so because they couldn't afford the exercise price or the associated tax, while 18% and 13% didn't exercise because they were worried about the financial risk or were worried about making a mistake respectively.
Tax rules for ISOs and NSOs
There are two types of employee stock options, often referred to as ISOs and NSOs. These options are available to employees in the United States. ISOs are “incentive stock options” and NSOs are “non-qualified stock options”. Both these options permit employees to become a part-owner of the company. Note that some companies offer RSAs (restricted stock awards) or RSUs (restricted stock units). These are not the same as stock options and we won’t be looking at them in further detail here, as the IRS treats them differently to stock options when it comes to matters of taxation.
Let’s take a closer look at how ISOs and NSOs are taxed. Stock options are usually taxed at two different points in time: once when they are purchased or “exercised” and later on when they are sold. ISOs are usually more favorable for employees as they may be subject to something called “Alternative Minimum Tax” (AMT) at the point of exercise. NSOs on the other hand may be subject to ordinary income tax at the point of exercise. At the point of sale, ISOs will be subject to either ordinary income or capital gains tax, and NSOs will be subject to capital gains tax.
There are many technical details on how ISOs and NSOs are taxed that we could explore further, however we are going to focus more on the practical outcome of these two stock options. Ultimately, ISOs and NSOs are designed to serve different purposes. ISOs serve better as employee stock options for startups, as they offer favorable tax implications for employees. ISOs are typically part of an employee option pool, the goal of which is to retain key hires at an early-stage of a startups life cycle. On the other hand, NSOs serve as a more suitable means of equity compensation, ideal for rewarding non-employees like contractors and other service providers, such as advisors.
💡If you want to better understand the tax implications of registering a company in a foreign country, check out our guide: How to Choose a Tax-Friendly Jurisdiction For Registering a Company in 2023.
This is a special valuation conducted by startups registered in America in order to actually assess the value of the company's shares and employee options and record how much they have grown in order to file the necessary reports with the tax authorities and have the opportunity to obtain exemptions.
409A Valuation is also conducted after receiving investments, and there's also a requirement to make it every 12 months. If it has been conducted, options must be issued at the new price (at Fair Market Value, as stated in the 409A Valuation Report).
This is already a more financial accounting question, and most financial advisors in the US assist with this. We simply want to mention this stage so it’s on your radar and you get the full picture of tax matters concerning stock options.
Cross-border legal considerations when issuing stock options
The most cross-jurisdictional issues surrounding the issuance of options arise when options are granted to team members who are located abroad. Typically, questions arise both on the company side and on the side of a team member located in a foreign country (a country different to the country where the company is registered).
Questions that usually arise on the company's side include:
- What type of option pool should be created for issuing options to foreign team members (approved or unapproved)?
- Is a company valuation necessary before granting options to foreign team members?
- What type of cooperation agreement should the option agreement be tied to for the foreign team member? (Typically, it is impossible to enter into an employment contract with team members located abroad, so companies will use freelance contracts or Employer of Record (EOR) platforms such as Deel or Rippling to engage team members abroad.)
Questions that arise from foreign team members include:
- How do I report the receipt of an option from a foreign company in the jurisdiction of personal tax residency?
- Are valuation reports from a foreign company recognized in the jurisdiction of personal tax residency?
- Can tax exemptions be applied in the jurisdiction of personal tax residency?
- What reports do I need to submit as a foreign team member to tax authorities in the country of my personal tax residency?
We highly recommend taking into consideration these questions when you prepare your startup's employee stock option plan and plan to issue stock options to employees in foreign jurisdictions.
Get started with stock options issuance
Well-issued options are always a very cool tool, both for founders and investors to grow their businesses and for employees to get the rewards of their dedication to the company.
If you've already set up your company (or looking to do so) and you need help with structuring your stock options issuance process legally, Legal Nodes can help.
We hold deep expertise on technology business legal matters, and work with legal service providers situated in 20+ countries. We can help you set up your option plan and issue stock options to team members no matter where you, your company, and your employees are located. Our most popular works on legal structuring for stock options is for businesses issuing options for the US or UK companies. You can learn more about this on our company maintenance use case page. As well as the popular jurisdictions, we also help with stock option issuance for countries such as Singapore and the Cayman Islands too by collaborating with our qualified professional services providers located there.
To get started, fill out a form on our website telling us what your stock issuance plans are and how you’d like us to help.