For many US startups, stock options are a crucial tool for attracting and retaining talent, incentivizing employees, consultants, and advisors. However, issuing options comes with intricate legal and tax considerations, and missteps can lead to costly complications. Here are five common pitfalls that US companies encounter in the process of granting stock options—and strategies to avoid them.

1. Assuming an Option Grant Has Been Made When It Has Only Been Promised

A commitment to issue stock options is not equivalent to an official grant. Formal approval from the company’s board of directors is required to execute an option grant. Including options in an offer letter or consulting agreement does not establish a valid grant unless it’s approved by the board. Failing to secure timely board approval risks the fair market value (FMV) of shares rising, which can increase the exercise price for the recipient, diminishing the intended benefit. To avoid this issue, establish a consistent board review process for granting options, especially for early-stage companies with infrequent board meetings.

2. Omitting Special Terms in Board Approvals

Special terms such as “double-trigger” acceleration upon acquisition are not automatically applied unless expressly approved by the board. It’s crucial that these terms, when included in employment agreements or consulting contracts, are also addressed in the board’s approval. Ensuring all promised terms are documented with board approval avoids potential disputes and compliance issues down the line. Consulting with legal counsel before finalizing offers helps align agreements with company policies.

3. Granting Options to Ineligible Recipients

Many equity incentive plans have eligibility restrictions, yet companies often grant options to ineligible parties, such as future employees, PEO-contracted service providers, or entities like LLCs. Grants to ineligible recipients can lead to securities law violations and tax issues, complicating future financing or acquisitions. Importantly, options can only be granted to active service providers. Before issuing grants, consult legal counsel to verify eligibility under the company’s specific equity plan.

4. Failing to Adhere to Incentive Stock Option (ISO) Requirements

Incentive Stock Options (ISOs) offer tax advantages but come with strict requirements. For example, options issued to individuals owning over 10% of company stock require a minimum exercise price of 110% of FMV and a five-year term. ISOs also have an annual exercise limit, beyond which options convert to Non-Qualified Stock Options (NSOs). Failing to meet these requirements forfeits favorable ISO treatment, resulting in unintended tax consequences. Legal counsel can help ensure ISO grants comply with these restrictions, especially for large grants, early exercisable options, or grants to major stakeholders.

5. Ignoring Federal and State Securities Laws

Stock options are classified as securities under US law, requiring compliance with federal and state securities regulations. Failing to account for these laws can result in penalties, compliance delays, and possible liability for the company. Different states impose varying requirements on stock option grants, which is why companies should work closely with legal advisors, supplying detailed information on optionee residency, grant size, and FMV before board approvals.

Additional Considerations for Non-US Recipients

Issuing options to non-US residents involves further complexities due to diverse tax laws, securities regulations, and employment practices. Without careful planning, grants to foreign service providers can trigger unexpected tax liabilities or regulatory filings. Companies should engage local counsel in any jurisdiction where options will be issued and consult tax advisors to ensure compliance with applicable US and foreign regulations.

Final Thoughts

Properly structuring stock option grants requires thoughtful planning and careful attention to legal and regulatory details. By understanding and addressing these common pitfalls, US companies can avoid costly missteps, maintain compliance, and foster positive relationships with their service providers.

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