Founders are plagued by a number of questions about option grants. Like any other startup securities, options have their own complexities and can be overwhelming to the uninitiated.
At TWO12, we have worked with 100s of founders and some of the typical questions we run into are:
Let’s break down some of these common questions around the option pool. But first, some fundamental concepts.
What happens at a company formation?
We’ll start with some basics. A startup is formed when founders register a business entity, in a state such as Delaware. As part of this registration process, the founders authorize some number of shares, say 10M shares. There’s typically also a par-value associated with these shares.
What are Authorized shares?
When startups issue shares, they are really issuing securities. Securities law requires that only certain types of entities (individuals or businesses) may receive these shares. However, the SEC has identified several exemptions that permit startups to issue these securities to founders, employees, advisors, consultants, friends, family, investors, and such.
By stating the total number of Authorized shares, the startup is indicating that it will issue a maximum of those many shares. In the future, as the company grows, the Authorized shares can be increased by filing an amendment with the state of registration.The reason why startups set a lower Authorized shares is due to potential impact from franchise tax. (See how Delaware calculates the franchise tax and its dependence on the Authorized shares.)
At TWO12, we have seen startups use Authorized Shares anywhere from 100 to 100M. There are significant implications for what should be used. Authorizing 100 shares means that an employee receiving 1% of the common shares will receive 1 share. There may be psychological barriers to incentivise your early employee with 1 share.
Our recommendation is to pick 10M shares at onset.
What is a Par Value?
Par value is the lowest price a startup will issue its shares at.
This is super important to grasp. Companies with par value of, say, $1 should not be raising at $0.25. (See this article about the importance of par value.)
Our recommendation is to use $0.0001 or similar for the par value at onset.
Is there such a thing called Founder shares?
There’s nothing special about shares issued to founders.
One of the first things the founders of a startup performs is to run a board consent that authorizes a specific class of Common shares with certain rights associated with it. These classes of shares would have a name such as ‘Common Class A’ and the number of shares authorized to be issued must be less than the total Authorized shares. Also, these shares may have different voting rights.
For example, a startup with Authorized 10M shares, could create 2 classes of Common shares.
In this example, the startup has authorized 5M ‘Common Class A’ shares with 10x voting rights, and issued all of 5M common shares – most likely to the founders.
The board has also authorized 2M ‘Common Class B’ shares with 1x voting rights.
This startup has allocated all of these 2M shares to the ‘2022 Stock Option Plan’, of which 745,000 have been issued.
So, of the total 10M shares, the company has allocated 7M shares, leaving 3M available for further expansion (without the need to register any increase in total Authorized with the state).
What are Fully Diluted Shares?
All outstanding and issued shares make up the fully diluted shares. This includes all the Common, Option Pool created, Preferred shares, and Warrants.
Convertible Notes and SAFEs that have not converted do not make up the fully diluted shares, as these shares don’t exist yet. In the future, when these instruments convert, they will get added to the fully diluted shares.
In the above example, the fully diluted share count will be 7M.
How are equity percentages determined?
All percentages use the Fully Diluted Share count.
This is very important for founders to understand.
Percentages are not based on the total Authorized shares.
So, if a startup has authorized 10M shares and the fully diluted shares is 7M, granting 1% fully diluted equity to an employee would be 70K shares (1% of 7M), not 100K shares (1% of 10M).
Too many founders mess up because they incorrectly use the authorized shares for their percentage calculations. This results in a lot more dilution than should have been.
How to think about your Options Pool?
Many founders assume that 10% is some magic number. There are others that go up to 20% and some even 25%.
There’s no one good answer, although 10% seem to be the most optimum based on our experience with startup cap tables.
The way to think about the option pool size should be based on your company’s hiring needs over the next 15-18 months. The idea behind this is that startups raise on average every 18 months, which in turn will result in granting more options or warrants to future shareholders.
So, if your startup does not plan to hire beyond the first 2 employees, and the intention is to grant them 1% each, you may very well start with a 2% option pool. It may be advisable to start with say 5% in this scenario, assuming the board changes its mind about option pool grants and wants to incentivise an outside advisor with options.
Should startups grant Common or Options?
It can be either, although a lot depends on the stage of the company.
It is important to understand that the IRS (or the equivalent taxing authority) considers Common shares as ‘cash equivalent’. This means that issuing an employee 100K shares can have tax consequences as the IRS can treat the equivalent as ordinary income.
This may not be of concern when the company is formed as the enterprise value is so less, that the par value can be considered a proxy for the per-share price. Assuming a par-value of $0.0001, a 2M Common grant is equivalent to a cash compensation of $200. The recipient will recognize this $200 as taxable income in their annual tax filing and incur a tiny tax impact as a result.
As the startup evolves, the enterprise value also increases. So, raising capital or generating revenue or running pilots or bringing on an established leadership team could all materially impact the startup’s value. This indirectly increases the value of the shares.
Assuming that the enterprise value has gone up to, say $0.50, now granting 100K shares to an employee will be treated by the IRS as a ‘cash compensation’ of $50K. This can have significant tax consequences to your employee.
This is the ideal time to be offering Options.
What are Options?
Options are securities that give the holder the rights to purchase the underlying security before a defined expiry date, after the shares have vested.
Options received don’t have immediate tax implications (but they do when exercised or sold).
So, at a strike price of $0.50, granting an employee 100K shares does not have an impact from the IRS standpoint.
Are all Options alike?
No. There are 2 types of options.
Non-Qualified Stock Options (NSO) and Incentive Stock Options (ISO).
From a high level, only employees are eligible for ISOs.
NSOs may be granted to anyone, including employees.
What’s the difference between ISOs and NSOs?
From a simplistic standpoint, ISOs are taxed only once – when the underlying stock gets sold in an IPO or M&A. So, employees holding ISOs don’t have a tax implication when they exercise their vested Options and convert to Common. They are taxed when they sell their Common in a liquidity event.
NSOs on the other hand are taxed twice. Once when the options are exercised, and the second time when the acquired Common shares are sold in a liquidity event.
Can Common shares be issued after an Option pool has been created?
Sure – nothing stopping from issuing Common after an Option pool has been created.
However, it’s a bad idea.
Founders have already absorbed dilution by creating the Option pool. Issuing more Common after the pool creation results in further dilution to the founders.
So, what is 409A?
409A is a tax ruling that provides a framework for how to arrive at the strike price for Options and Common shares.
As mentioned in this post, the IRS wants to ensure that shareholders will pay the appropriate tax for their equity compensation. An experienced 409A service provider would typically look at multiple aspects of the startup as of a valuation date, including financials, projections, team bio, industry, segment, competitors, comparables, and such; and use different financial modeling relevant to the startup to arrive at the strike price.
Failure to comply with 409A rules can result in severe penalties and added tax burden to the shareholders.
TWO12 is here to help founders mitigate these landmines. Mistakes done early on are nearly impossible to fix. TWO12’s suite of equity management products are founder friendly – both from user experience and price. Visit https://two12.co.