Equity incentive plan basics

At formation, founders often ask us for recommendations regarding terms and structure of their companies’ incentive stock option plans. When making these recommendations to new companies, we generally advise that founders choose relatively “standard” and “straight-forward” terms, which have the dual benefit of keeping legal costs in check at formation and signaling to potential investors that the company’s “house is in order.” Although individual circumstances may dictate deviation, below are some high-level recommendations regarding equity incentive plan structure:

1. Size of Stock Option Pool. Typical range is between 5% and 20% of the company’s fully diluted capitalization. Pool sizing, though, is obviously dependent on hiring needs, which can vary widely depending on a company’s particular circumstances.

2. Authority to Approve Grants. In order to comply with IRS rules, and for other corporate governance reasons, in a company’s early stages, only the company’s board of directors is typically authorized to approve options grants. In later stages, boards often delegate this authority to a committee of the board; however, until IPO, companies don’t typically allow officers alone to grant awards.

3. Types of Awards. Early-stage companies typically use primarily stock options and, in some cases (where the tax and corporate governance implications are understood and warranted), restricted stock grants. This approach keeps both the equity incentive plan itself and administration of the same more streamlined and avoids a number of tax and accounting associated with more complicated forms of award, like Restricted Stock Units (RSUs) and Stock Appreciation Rights (SARs).

4. Types of Options. Because Incentive Stock Options (ISOs), which can only be granted to US-based employees, allow for potentially better tax treatment to the recipient than Nonstatutory Stock Options (NSOs), many companies default to granting ISOs for all domestic employees. However, because that preferential tax treatment requires exercise of the options at least one-year prior to a sale, many employees don’t take advantage of the benefits provided by ISOs – and don’t appreciate the nuance at hire. Accordingly, some companies grant NSOs as a default, reserving ISOs for more senior employees that are likely to understand and avail themselves of the benefit.

5. Term of Option. IRS rules require that ISOs survive for no more than ten years in order to be treated as incentive stock options, so this is the default term used in most equity incentive plans, even when NSOs are granted.

6. Early Exercise Feature. Allowing options to be exercised before they are vested involves a number of administrative complexities (eg, 83(b) filings, repurchase of unvested shares at termination, etc.) and has corporate governance implications (as stockholders are entitled to significantly greater rights (eg, voting rights, certain information rights, etc.) than option holders). Accordingly, most early-stage companies do not, as a default matter, allow early exercise and instead permit only in particular circumstances where the complexities are understood by the optionee. Where an “early exercise” feature is used, we recommend the use of NSOs rather than ISOs (to avoid AMT complications) and that the optionee take immediate advantage of the early exercise feature.

7. Vesting. Early-stage companies generally grant new employees equity awards that vest monthly over a four-year period with an initial one-year “cliff” period from the date of hire (rather than the date of grant). Grants to advisors or contractors and refresh grants to employees often have more bespoke vesting schedules dependent on the particular circumstances.

8. Acceleration upon a change of control. Although executive hires and re-fresh grants sometimes require “double trigger” acceleration to protect the executive from a termination following a change of control, investors and potential acquirers generally disfavor acceleration (particularly “single trigger” acceleration), as it can adversely impact post-closing employee incentives and the acquirer’s ability to use ongoing vesting as a retention tool. In addition, default acceleration for all optionees can create mis-alignment of incentives between longer-term employees (who are largely vested and receive moderate or little acceleration) and newer hires (who may receive a relative windfall acceleration benefit). Accordingly, we generally recommend against including any default acceleration in the option plan itself and instead recommend granting the board flexibility to provide for acceleration (or any other non-standard vesting) in specific grants to key employees, or to amend existing grants for all employees if and when an acquisition occurs. This approach allows the company to maintain maximum flexibility in attracting investors and negotiating the terms of potential acquisitions, while also giving the board flexibility to incent key employees at the point of a sale transaction.

9. Post-Termination Exercise. Again, because IRS rules require that ISOs be exercisable for no more than ninety days following an employee’s termination of service, most option plans include this default post-termination exercise period even for NSOs (except in the case of death or disability, in which the exercise window is typically twelve months).

10. Transferability of Options. Non-transferability of options is not only required to comply with the federal securities law exemption under which most options are granted but is also advisable from the perspective of controlling a company’s stockholder base by preventing non-service providers from holdings options or becoming stockholders.

11. Right of First Refusal; Repurchase Rights. In order to limit its stockholder base to persons connected to the company, most early-stage companies include in their incentive plans a company right of first refusal over transfers of vested and exercised shares (with customary exceptions for certain family and estate planning transfers). In addition, although infrequently used, some companies also include a vested share repurchase right that allows the company to repurchase vested and exercised shares at then current fair market value upon the optionee’s termination of service.