\u00a0<\/em><\/strong>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/em><\/strong>The truth of this statement may be obvious, but the execution of a good incentive program using equity is often mismanaged, damaging the corporate capitalization structure and even affecting the outcome of subsequent investment into the company.<\/p>\n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 First, a brand new enterprise is often formed from the efforts of several \u201cpartners\u201d, each with an expertise valued by the others.\u00a0 Equity is divided between the founders and the business begun.\u00a0 Although this insight does not address this point of ignition, we should note in passing that things always change over time, and formerly strong founder-contributors can become a drag upon a business or loose interest if the enterprise is not quickly successful.\u00a0 To protect against this, there must be some document in place from the beginning that clearly states the expectation of each founder as to contribution of time and resources to the enterprise.\u00a0 The document should also contain clear buy-sell clauses, forcing any sale of shares to first be offered to the corporate treasury, then to the other founders in proportion to their holdings, and then if no interest, to outside investors.\u00a0 It should contain a mandatory sale clause in the event of separation of a founder, so that a major owner who is passive in the enterprise cannot easily vote against measures other active founders endorse.\u00a0<\/p>\n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 The real insight here is that stock options or phantom stock are the tools of early stage businesses used to attract great talent when there is not enough cash to pay market rates.\u00a0 There are some rules.\u00a0 First you must create a stock option plan using your attorney, which must be registered in many states as a security offering. (The fee for registration is well under $100, so this is not an issue.) \u00a0Options are usually best with \u201cC\u201d corporations, but granting options for either LLC\u2019s or \u201cS\u201d corporations are not a real problem.\u00a0<\/p>\n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Most early stage companies make the mistake of making option grants to new hires at all levels that are too aggressive and distort the capital structure of the company to a degree that damages future professional investment.\u00a0 Let me try to advance a few rules of thumb to help guide you here.\u00a0 [Email readers continue here…]<\/em> <\/span>An option plan should carve out an addition of about 15% of the \u201cfully diluted\u201d shares.\u00a0 If there are 85,000 shares issued to the founders, then a plan calling for 15,000 shares in a pool reserved for future hires is appropriate, making the fully diluted shares 100,000.\u00a0 The board must approve the plan including this number, and shareholders must approve the plan as well.\u00a0 Each grant to new or existing employees must be approved by the board before issue.<\/p>\n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 The price per share for option grants is also an important consideration.\u00a0 IRS rule 409a specifically calls for an appraisal of the value of the corporation\u2019s stock current to within a year of any grants of options, although there is an exclusion for early stage businesses in which expert members of the organization or board may make such an appraisal if they qualify according to the exemption.\u00a0 It there is only one class of stock, the same as the founders, and the appraisal of the single class of shares yields, say $2.00 a share, then options must be priced at that amount.\u00a0 In other words, you cannot create bargain options at below \u201cmarket rates.\u201d\u00a0 If you have a preferred class of stock with special protections, that class of shares will be valued at a price higher than the founder common shares, allowing stock options to carry a lower price per share than preferred investors may have paid.\u00a0 This is important because high quality candidates should be induced to consider coming aboard at lower than market salaries using the tool of \u201ccheap\u201d options, properly priced.<\/p>\n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 What percentage of the total company shares should be reserved for what specific job titles?\u00a0 Inducing a new CEO to come aboard usually means creation of a stock option package of 5-8%. That size of grant would take much or most of the option pool.\u00a0 A vice president, or CxO candidate, typically is offered between 1% and 1.5%.\u00a0 Director level employees are typically granted \u00bd%.\u00a0 All other grants usually are much lower, allowing for the typical 15% pool to last for quite awhile in most companies.<\/p>\n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 We will cover board members and advisory board members at a later time.\u00a0<\/p>\n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Options typically are earned over time, which we call vesting.\u00a0 If a grant of 10,000 shares is made on January First, typically there is a four year vesting period in which the employee earns the right to exercise (buy) 1\/48th <\/sup>of the shares each month.\u00a0 Many plans also call for a one year \u201ccliff\u201d in which an employee who is separated from the company before a year is unable to exercise even the shares which would have been vested at that point.<\/p>\n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 There is an important consideration that will become an issue with sophisticated candidates for VP and above.\u00a0 We call these \u201ctrigger\u201d provisions, in which selected options negotiated for a select group of senior managers, fully vest to 100% upon any change of control.\u00a0 This provision allows these select individuals to perhaps profit handsomely in an acquisition by being able to exercise their options in full at the time of sale.\u00a0 The negative side of this is that the buyer may not want to so enrich these managers that they may not be willing to come aboard the buyer\u2019s organization, even if the existing options are replaced with options from the buyer company.<\/p>\n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 If all of this seems a bit overwhelming, we have just scratched the surface of option plans and incentive compensation.\u00a0 This is an area of expertise that a CEO is required to quickly learn and carefully manage with the help of the corporate attorney and the board.<\/p>\n","protected":false},"excerpt":{"rendered":" Equity is the currency of early stage businesses. \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 The truth of this statement may be obvious, but the execution of a good incentive program using equity is often mismanaged, damaging the corporate capitalization structure and even affecting the outcome … Continue reading