Avoid these common mistakes when issuing stock options to employees

Author: The Carta Team
Published date: 2 December 2020
Read time: 4 minutes

Issuing options is a complex and delicate process. Avoid these five common mistakes to make sure you're doing it right.

1. Getting the timing wrong

Once you’ve decided to grant options, it’s critical to make sure you time these issuances correctly.

For example, issuing options late (e.g. after you’ve received an investor term sheet) may force you to grant those options at a higher exercise price than you originally promised to your employees. As a result, they may be less motivated to exercise their options, or even worse, feel uninspired to stick around.

That’s why it’s often a good idea to issue stock options before you have a term sheet in-hand. By doing this, you allow your employees to take advantage of a lower exercise price.

2. Failing to get a 409A valuation (or update your previous one)

Before issuing options as a private company, you need to get a 409A valuation to determine the fair market value (FMV) of your company’s common stock. This FMV helps you set the strike price, or the legal purchase price for each share.

If you don’t have a valid 409A valuation on file when issuing options, you risk exposing your company and employees to all sorts of potential tax penalties from the IRS. For example, if you issue options with a strike price that’s lower than the legally-defined FMV, your employees could be charged significant interest penalties.

A one-time valuation also isn’t enough. To avail yourself of the 409A safe harbor with the IRS, you need to get a new 409A valuation every 12 months, or sooner if you have a material event or transaction, (like a new financing round).

3. Not getting board approval for issuances

Another mistake many early founders make is issuing options without their board’s approval first. The board has to approve all stock option grants ahead of time, either at a board meeting or by unanimous written consent. If your board hasn’t approved an option grant, no options have actually been granted.

By the time you realize this as a founder, it could be too late. You may need to re-issue the stock options, and depending on how much your company’s value has grown between now and then, these new options could end up carrying a higher exercise price than you originally promised your employees.

4. Thinking all stock options are the same

There are a few different types of stock options you can issue—each with their own implications for your business and employees.

The most common types are incentive stock options (ISOs) and non-qualified stock options (NSOs). They differ in a few ways, namely: 1) whom they’re for and 2) how they’re taxed.

5. Failing to correctly track vesting schedules

Neglecting to create a proper vesting schedule can have dire consequences for your company’s retention and cap table.

Cliff vesting is when employees receive 100% of their stock options all at once after a stated period of time.

Graded vesting is when employees receive a portion of their stock options gradually over a certain number of years until they’re fully vested.

Setting your company up for success

Making mistakes when issuing options can cost you time, money, and in the worst case, valuable employees. To avoid inadvertently complicating your cap table or de-incentivizing your team, it’s important to make sure all your ducks are in a row before you issue stock options.