Startup Stock Options: Granting and Pricing

Startup Stock Options by on April 30, 2007 at 10:15 pm

OK, So far we’ve touched on the the two types of options and vesting schedules in this series. The type of option has an impact on some of the content in this section, so take a quick read of the ISO and NSO post if you’re unfamiliar with the different types of options.


How options are granted

Startup options are granted by the board (in nearly all circumstances). This is required by state law in nearly all states, although there are exceptions (I’m way out of my league discussing the exceptions). Startups rarely have compensation committees similar to those in public companies, so option approvals are typically conducted during a board only session at board meetings.

Options are granted from an existing pool of stock that has been set aside for employees. This employee pool is commonly set aside during formation or during a financing round. Boards can always issue more stock, however this reduces the ownership of all stockholders (and may trigger investor anti-dilution clauses), so it tends to be infrequent and is nearly always associated with a financing activity.

Options outlined in offer letters aren’t granted until after they have been approved at a board meeting. If the grant is particularly large (for example, key personnel), most CEOs will have reviewed the numbers with the board in advance. Although nothing is truly final until you receive the grant, companies obviously do their best to ensure that grant numbers don’t change.

Differences between ISOs and NSOs

In order for an option to meet ISO requirements, the plan that provides for the grant of ISOs must:

  • Be approved by shareholders within 12 months of its adoption
  • Specify the total number of shares available for grant under the plan
  • Specify the types of employees eligible for grants under the plan

Typically, a company adopts a single stock option plan that meets the requirements for ISO options, but allows for grants of both ISO options and NSO options. The type of option is then determined by the Stock Option Agreement signed between the company and the employee.

As an employee, there are typically 3 documents associated with an option grant:

  1. Stock Option Plan - The plan adopted by the stockholders that outlines the key components of the stock option plan, such as who has authority to issue options, the type of people eligible for options and the number of shares available for grant. This plan can be amended by the board. This plan is incorporated by reference in the Stock Option Agreement and the Notice of Grant. This is not a document that you sign. The key things to be familiar with in this agreement are the size of the employee option pool and the types of options allowed.
  2. Stock Option Agreement - The agreement between you and the company that details what type of option you are receiving, details of the vesting provisions, change of control events, transferability, etc. You’ll need to sign this document (usually only once).
  3. Notice of Stock Option Grant - The actual grant of options. Typically a one page document that states the key criteria for the grant: date, # of options, vesting schedule, exercise price, etc. You’ll receive and sign these documents with every new grant.

How options are priced

ISOs are required to be granted with an exercise price at fair market value, while NSOs can be granted at any value (typically at or below fair market value).

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Pre-409A: (I’m including this paragraph for nostalgia…) Options were priced by the board from time to time. After reviewing the progress of the company the board would raise (or lower) the price of common stock based on the progress of the company. This price was always at a discount to the preferred price (the price investors pay), representing the additional value of the preferred stock privileges. Generally common stock was priced at 5-15% of the preferred price.

Post-409A, things are different (and way more expensive). Brad Feld’s posts on 409A are the most complete I’ve seen, but I’ll summarize the impacts here. To avoid 409A penalties, the fair market value (FMV) of the options is typically determined by an external appraisal. Costing ~$10K, these appraisals are an important component of 409A avoidance. ISOs are then issued with exercise prices determined by the valuation. Section 409A also strongly encourages NSO prices to be set at FMV. If they are set below FMV, 409A requires that employees pay taxes on the difference between the exercise price and fair market value when the option vests. This means that startup employees could end up paying taxes on unexercised vested options that have no liquid market for sale. Penalties ensue if the IRS determines that the startup issued options below FMV and the employees did not pay taxes when they vested their options.

Startups need to update their option valuations from time to time to keep their option grants in line with the value of the options. 409A safe-harbor provisions require independent valuations to have been conducted within the prior 12 months. Significant events (patents issued, big partnerships, etc.), would trigger a need for a revaluation. Presumably, follow up appraisals can be had at a discount to the initial appraisal.

All grants made after a price increase would of course carry the new exercise price, and prior grants would be unaffected.

Next time around, I’ll touch on the different aspects of early exercise.
  • S.W

    Your posts on this topic is well written and very help.

    Thanks a lot

  • chris

    Hi. Thanks for the post. Im starting in a new startup. The founder states to me orally that he is giving me a 1% equity stake in the Company. When the offer letter comes, he is granting me 150,000 options. To my mind, and equity stake is stock – not options. Am I wrong on that?

    • Yes, you're wrong on that.

      Options and Stock are effectively the same thing at a startup.

  • JAime

    Can a company change an employees option from an NSO to an ISO if the employee is later hired?

  • Manny.K

    Dave, thanks for the super helpful information, discussions and links. I've not found better, more comprehensive or easier to digest information anywhere and I've been researching this topic for weeks.

    I do have a question for you though. As part of a pre-revenue startup (that was founded over 4 years ago and in development for years prior) that is interested in paying back working founders and consultants that have had deferred payments accruing from consultant agreements, and wanting/planning to compensate them using NSO options (we have a plan in place, but have not made use of it as yet), how does one go about valuing the NSO option grant price?

    Applying Black Scholes is a bit beyond our ken, but we believe that the options should be offered at an advantageous below FMV rate (perhaps 5x) and in a quantity that will allow the consultants to be equitably compensated for cash owed including the cash they'll have to lay out to execute the options, excluding taxes…..we're just not sure what rules govern this practice, and/or what method we should use to arrive at the grant price and whether there are implications for offering the grant at to low a price. Of course, our plan is to remove the debts in exchange for the grants so there needs to be a compensatory nature to the exchange.

    Any input would be much appreciated. As a group we've all run successful creative businesses that have only had single owners or small partnerships, we've been facing a huge learning curve as we prepare the company for its first rounds of outside investors.

    • Manny,The typical guidance on determining FMV for a NSO is to have thenvalued. IRS guidance seems to be pretty clear on the type oforganization that can value them (and it generally excludes boards).There are a number of companies that make a business of performingthese valuations.Also be careful around the option grants. They will be taxable at thedifference between the grant price and the FMV. Yuck.I would highly suggest you consult with a tax professional on this.Anyway, good luck!Dave

  • Ra

    nice articles and answers too.
    I had a question for you.
    I was granted N stock-options (pre series-A) when my company was angel-funded. After series A funding, I was told that the strke price would be determined on that series A round, since they had no proper valuation when I joined. I am not buying it, and it seems unfair becaue I get diluted and also pay a much higher strike price.
    My lawyer friends say that I should have been given a strike price at the time of the grant (when I joined), and my work has contributed to the much higher valution in the Series A.
    What is your opinion and what are the legalities involved here?

    • Every time I've seen an options agreement, the strike price is set at
      the time of grant. as part of your option agreement. It is common
      that new option agreements need approval from the board before they
      are effective and can sometimes lag the date that they are verbally or
      otherwise granted. Usually there is language in the letter (if it is
      an offer letter) of something along the lines of 'pending approval by
      the board of directors'.

      Keep in mind I'm not a lawyer – I'm just describing what I've seen in
      my limited experience.

  • Jalmm

    Dave, very helpful, thanks for sharing!
    i have one question related to grants made poat 409a. i'm about to join a startup that just went through a second round of financing, and had to file 409a. the valuation went from a few cents to almost a dollar. the hiring manager pointed out it would affect the stock / option i'd get. does it mean i get less stock now then someone who joined say 6 months ago? what are the usual disavantages of getting stock post 409a?

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