Equity Incentive Plans (aka, Stock Option Plans) are a standard feature in nearly every start-up.  Although the basic concept (granting an equity interest to an employee or other service provider) is simple enough, there are a few administrative and legal technicalities that need to be respected.  Below is a list of five common mistakes that start-ups make when administering their Equity Incentive Plans.

1.  Human Beings Only^[1]

Only an actual human being can receive an equity grant under an Equity Incentive Plan.  The flip side of this rule is that legal entities (e.g., corporations, limited liability companies, etc.) cannot receive options or other equity under an Equity Incentive Plan.  This issue often arises when a consultant is providing services and is employed by or otherwise operates a separate legal entity.  While it is okay to grant the individual consultant equity under the plan, equity can’t be granted to the legal entity itself. 

Bonus tip:  If you are retaining a consultant through an entity, and want to grant equity to the consultant individually, make sure that the consulting entity itself acknowledges that the grant to its human employee is in satisfaction of any obligation to issue the entity equity.

Bonus tip part 2:  If you absolutely must grant the equity to the entity, and not the individual, you can do so outside of the Equity Incentive Plan.  However, you will need to confirm that you have a valid state and federal securities law exemption and that issuance will often be subject to rights held by any outside investors (e.g., a right of first refusal, anti-dilution adjustments, etc.). 

2.  Current (not Former, not Prospective) Service Providers

Equity Incentive Plans are intended to compensate persons providing services to a company.  If the person has not yet provided services (e.g., they are scheduled to begin their employment or consultancy in the future) or if they are no longer providing services (e.g., they’ve resigned or their agreement has been terminated), they are not eligible to receive a grant under an Equity Incentive Plan.

3.  Milestones

Most grants of equity under an Equity Incentive Plan are subject to some form of vesting, with time-based vesting being the most common.  Time-based vesting is typically on a schedule known as four year vesting, with a one year cliff.  Under this vesting structure, none of the equity vests until the one year anniversary of the vesting start date, at which point 25% of the equity vests (i.e., the one year cliff).  The remainder typically vests in equal monthly or quarterly installments thereafter until everything is vested after 4 years.  In order to vest, the holder must be providing services as of each vesting date.

The virtue of time-based vesting is that time is objectively measurable and serves as a useful proxy for measuring whether or not work is being completed in consideration for the equity.  If the employee or consultant is not performing adequately, their services can be terminated, and vesting ceases.  The one year cliff provides a period of time for both parties to settle into a relationship and determine whether or not the relationship will be viable on a longer-term basis.

However, sometimes a company may want to grant equity and tie the vesting to the achievement of specified milestones.  This is fine, provided that the milestones are clearly defined so that each party understands what triggers the vesting.  Therefore, a vague milestone, such as “the achievement of such goals as are mutually determined from time to time” or “at the discretion of the Company,” won’t work – no valid contract is created because neither party has specified its obligations.  The best milestones are those with concrete goals that can be objectively measured, such as meeting a sales goal measured in dollars or identifying and recruiting a new engineer who stays on for at least six months.  If the goal cannot be objectively measured (e.g., creating a new GUI for the company’s app), it’s important to identify who makes the subjective determination.  In most instances, the company will want that to be its board of directors or officers. Even if the goal is seemingly objective, it still is best to have the Board or an officer determine that the milestone actually occurred and have that determination be the vesting date.  This allows for the vesting date to be fixed to a time when all agree, which is particularly important in the event that the employee leaves and it is later discovered that the milestone had occurred prior to termination.  Finally, it is important to provide for an outside date for achieving the milestone to provide for certainty that the obligation to vest the equity doesn’t continue in perpetuity.

4.  Determining Fair Market Value

Equity grants to employees and directors must be made at the fair market value as of the date of grant.  If they are not, the company and the person receiving the grant may suffer serious adverse tax consequences.

Determining the fair market value of the equity of a private company is a difficult task.  The shares aren’t publicly traded, meaning that there isn’t a stock quote readily available.  A company may have conducted a financing recently which sets a valuation as part of the process, but most early financings consist of convertible notes or classes of equity that are not the same as Common Stock (e.g., Preferred Stock), and the prices paid for those instruments may not accurately reflect the fair market value of the Common Stock issued under the Equity Incentive Plan.

The best way to proceed is to retain an outside valuation firm to determine the fair market value by conducting a valuation in compliance with Section 409A of the Internal Revenue Code, “409A valuation.”  This valuation takes into account a number of factors, including discounts for lack of liquidity or control, the value of comparable companies and the likelihood of generating revenue or selling the business in the short and long term.  A formal 409A valuation report will be produced by the valuation firm, though it must still be reviewed and approved by the board of directors of the company.  The advantage of this report is that it shifts the burden in the event the IRS ever investigates the company’s equity grants – the IRS must demonstrate that the report is incorrect rather than the company demonstrating that it is correct.  The disadvantage of this report is that there is a cost – typically around $5,000 – and such reports can only be relied upon for a period of 12 months following preparation.

If a company does not want to incur the expenses of a 409A valuation report, it may instead have the board consider the factors noted above (along with those other factors that the board deems relevant to the determination) and make its own conclusion regarding the value of the company’s Common Stock.  Unlike the formal 409A valuation report, the burden is on the Company to demonstrate that the determination was correct in the event of an IRS investigation.  If the members of the board are not experienced in making valuation determinations of private companies or did not thoughtfully consider the factors noted above in determining the fair market value, it will be difficult for the Company to satisfy this burden.

Bonus Tip:  Any valuation, whether prepared by an outside valuation firm or internally by the board, is only good for so long as it is current (i.e., 12 months assuming there are no material changes to the Company’s business).  If there is a material change in your business (e.g., a new financing, a major customer coming on board or terminating its relationship, a significant lawsuit against your critical IP), you will need to update your valuation.

[1] Technically, there are certain instances where single member limited liability companies, revocable trusts or similar entities can hold an equity interest granted under an Equity Incentive Plan.  However, this typically arises upon the death or disability of an actual human being and the transfer of the equity interest to their estate.  However “Human Beings and Certain Single-Member Disregarded Entities and Trusts Relating to Estate Planning Matters” is a less clear rule of thumb, so this article errs on the side of memorability over technical correctness.