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💡 Before we get started, a HUGE thanks for Kristin O’Hanlon and Cooley for being the go to lawyer for these specific questions on US equity. For related issues in the international context, make sure to check out Easop
💡 Second - nothing in this blog is legal advice, just a list of common mistakes that occur in this domain. Let’s get to it!
1. Not filing an 83(b) election as a founder or an early employee receiving common stock or early exercising options
83(b) elections are counterintuitive: you ask the IRS (U.S. tax authorities) to tax you now on all shares, even the unvested ones. Why would you want to accelerate tax 🤨?
Well, if your company has just been incorporated, your stock is likely to have a very low value, so if you acquire that stock by paying a low fair market value and file your 83(b) election on the unvested stock, then your ordinary income taxation – basically, the federal tax that normally applies to salary and other employee compensation -- will be 0.
By requesting to be taxed on the value of all stock, including stock subject to vesting, you can avoid being taxed later once the stock vests (and has a potentially higher valuation).
You need to file an election to the right IRS office (welcome back to the 1980’s), within 30 days of the date on which the common stock is transferred to you.
What if you don’t do it or miss the deadline? Well, there’s unfortunately no easy way to fix it (at least without tax risk), so be careful!
2. Not requesting a 409A valuation before granting options in order to save money
Early stage companies are cash sensitive. Probably the last things you want to spend money on as a founder are legal and administrative tasks 💸.
Why, then, spend money on a 409A valuation (to help set the exercise price of options), when you can simply make up a value? It’s not like there’s much substance when you’re that small anyway, right? The company is just a bunch of people with a great prototype, a few beta partners and an ambition to become the next unicorn - it’s all paper value without any real market proof behind it.
Well, it’s a bad idea, because of the tax implications that granting options at a discount can have on the company and the employee.
At your next round, investors may require a retroactive valuation. You would have to go back in time and show that the options were not granted at a discount. This can delay a funding (or M&A process) and legal costs will go through the roof.
Options may have been granted at a discount, triggering some gnarly (hello again, 1980s) consequences:
Options you thought were ISOs will, in fact, be NSOs, because ISOs must have an exercise price equal to at least fair market value as of the grant date.
As the options vest, the employee will be considered as receiving a benefit equal to the difference between the exercise price and the fair market value of the shares at vesting (and as an employee you need to pay withholding on that, even though you haven’t received any profit from the options yet).
There’s a penalty (and interest) tax at the federal, and sometimes state level, which will continue to accrue.
🌍 What if you only have employees outside of the U.S. who are not considered U.S. persons? Can you grant them options without a 409A valuation
Well, you might get away with it (because 409A valuations are a product of U.S. tax law). But even then, having a 409A may be useful to prove the valuation of the company at a given time if you’re facing an investigation from foreign tax authorities.
Offering options at an exercise price lower than the value of the stock at the time of grant sometimes gives rise to a taxable benefit that you have to report to foreign tax authorities. Being able to show that the exercise price reflected the valuation at grant could help you, even if there’s no assurance the local authorities will consider a 409A valuation as a valid method for determining a stock price. That being said, the tax authorities will generally have to show why they consider a 409A valuation to be invalid, which is often not going to be simple. So in most cases, it’s just safer to have the valuation done.
Another possible snag: if employees outside the U.S. are granted discount stock options and they are or become a U.S. taxpayer while the option vests, they could become subject to adverse tax results similar to those described above.
3. Forgetting to renew your 409A valuation
A 409A valuation is only valid for 12 months at most ⏳ and provided that no event that materially affects the value of the company takes place in that period.
A lot can happen in 12 months, especially for companies doing well. Some companies will either forget that they need to request a new valuation after certain events happen, or consider that they can keep on granting options under an expired 409A valuation because nothing significant has happened in the life of the business.
Some companies will also rush to make new grants before the 409A expires, assuming the fair market value will become higher with the new 409A valuation (and so the exercise price will increase for their employees). ✋ In those circumstances, it can be difficult for companies to defend granting options at a value reflected in the existing 409A valuation when a new 409A valuation indicates an important change in valuation as of a short period later.
4. Promising grants without a board approval or without specifying essential parameters of the grant
Every grant of equity award requires a decision from the board (or a committee, if it has been specifically set up by the company in accordance with the equity plan). There’s simply no shortcut you can take here.
In the board approval, you need to find all the required parameters of the grant: person receiving the grant, maximum number of shares subject to the grant, class of shares (usually common stock) and minimum exercise price. If certain key terms such as vesting acceleration or early exercise have been negotiated, they should also be found in the board consent.
When using Easop, you’ll see that you can’t grant equity awards without the approval of all board members who receive access to the platform. That said, using Easop, board members can not only sign on to the platform directly, they can also visualise the impact of grants on the company ESOP pool ✨ Get started
5. Stating a fixed exercise price in offer letters to candidates
The exercise price should be equal to (or greater than) the fair market value of the shares on the grant date. If you want to attract a new candidate who wouldn’t start right away, it’s tempting to put the then-current fair market value in the offer package provided to this candidate. ✋ You shouldn’t, because there is no certainty that the person will benefit from the exercise price stated in the offer letter, as the fair market value of the stock may of course increase (or decrease) by the time the grant is made.
💡 In the Easop offer letter tool, you can create an offer letter which will expressly states that the strike price is current and based on fair market value, and that it is subject to change.
6. Granting equity to a candidate who hasn’t started yet
Sometimes companies want to be too quick and offer equity immediately. Under a typical equity plan, only service providers who are in service on the grant date can be granted equity. In practice, this means that you can’t grant equity until the candidate has officially joined the company as a service provider (whether it’s an employee, a contractor or an employee employed via an Employer of Record).
7. Not timely approving an exercise request
Most companies use an equity platform like Carta. When someone exercises on Carta, the fact that the employee asks to exercise doesn’t mean that the exercise is effective.
The company needs to approve the exercise on Carta, and it’s only then that the employee will be able to complete the exercise process and receive their stock. If the company waits so long that the option expires, or that the fair market value increases (and therefore the tax due on the spread also increases), the company will be in a bad situation vis-à-vis the employee.
Discover the future of stock option management with Easop. Your journey to seamless, compliant, and hassle-free stock option management begins here 📈
