Two Places a Start-up Shouldn't Skimp on Documentation

Here’s a story you might have heard before.  Fantastic Start-up, Inc. built a nice little business, from two founders and no revenue to 37 employees, 20 paying customers and revenue of $3.8 million last year.  It took four long, hard years to get here, but now a VC firm wants to invest, and Fantastic Start-up could do some good things with that money.  Due diligence started last week.  And it doesn’t seem to be going all that well.

For some reason, the accountants they sent over keep asking about the company’s stock option program.  They want to see board minutes, valuation reports, copies of the option agreements themselves, even offer letters.  Offer letters?  What’s going on here?

Fantastic Start-up might have some unhappy news coming its way.    

Founders of technology companies are usually wonderful technology people; they can be brilliant marketers, too, and sometimes really good with people.  But they don’t always understand the finer points of finance.  Or administration.  Or taxes.  Or securities.  

They will learn these things, sure enough.  Smart people don’t have any trouble absorbing and retaining legal rules.  But if you’re an entrepreneur and it’s your first rodeo, learn the ropes or learn from painful experience.

Problem Area No. 1: Stock Option Disarray  

I’ve seen it in real life -- a technology start-up learns about expensive tax and securities problems during an investor’s due diligence examination.  It’s embarrassing.  It can reduce the company’s valuation.  It can even kill the deal. If you have a young company that offers equity to employees, one of the most cost-effective things you can do is to bring your stock option or restricted stock program into compliance.  It’s quite easy and inexpensive to set things up the right way at the beginning.  But with each new grant, it becomes harder and harder to straighten out problems.    

Documentation is the easy part.  Your law firm can provide you with a package of unified documents, including:

• A stock incentive planBoard and shareholder resolutions for approving the plan

• A template for incentive stock option agreements

• A template for non-qualified stock option agreements

• A template for restricted stock agreements

• Template agreements for phantom stock and stock appreciation rights, if desired

• A plan description document (if total grants are over $5 million in one year)A form for making 83(b) elections with the IRS

• Wording for option awards in employment offer letters

Don’t try to make this stuff up on your own, or retro-fit a form you found with a Google search.  If the law firm you use has any business practicing in this area, they can provide you with a plan, resolutions and templates that are fully integrated and legally compliant, all more or less off-the-shelf.

Follow the legal formalities.  Before making any awards (including informal promises), take these legal steps:

• Have your board of directors approve the plan

• Have your shareholders approve the plan; although the federal tax code allows approval within the next 12 months, I recommend prompt approval

• Determine whether state “Blue Sky” filings are required.  In Massachusetts, they are not; in other states (e.g., CA), they could be

• Create a system for tracking grants. Excel spreadsheets can do it, but specialized software is better, and usually priced cheaply for small private companies.  (It’s a loss leader for the vendor, and they’ll jack up your license fees when you get bigger or go public.)

The importance of periodic company valuations. Stock options cannot have an exercise price that is below the fair market value (FMV) of the underlying security on the grant date, unless you want to subject the grantee to the likely pain and expense of a deferred compensation excise tax under Internal Revenue Code section 409A. The value of restricted stock is taxable, either at grant or at vesting, depending on an election that the recipient can make. (See my earlier blog entry, “Restricted Stock Basics.”) Both options and restricted shares must be accounted for as compensation expense by the issuer, and for this a valuation must be assigned. Valuation, in other words, is important. You really can’t ignore it if you’re handing out equity in exchange for services.

Until the company’s securities are traded on a public market, the FMV of the company must be determined by its board of directors, using a “reasonable application of a reasonable valuation method.” Valuations can be second-guessed, especially if they are stale or overcome by subsequent major company developments, by:

• The IRS (incentive stock option treatment, section 409A)

• The SEC and State Securities Regulators (concerned about accuracy of compensation expense)

• Investors (also concerned about accuracy of compensation expense)

So should you hire an independent valuation consultant? Doing so offers a safe-harbor from IRC section 409A, good for the next 12 months (unless a major company development, like an arms-length investment, compels a new valuation). And it would be a good defense against securities claims that compensation expense was understated. But ultimately, boards of directors are allowed to make their own reasonable determinations.

Don’t forget the securities laws. Private companies need to comply with Rule 701 under the Securities Act of 1933. The aggregate value of all options they grant (exercise price x number of shares) and outright stock, restricted or not, may not exceed the greatest of the following in any 12-month period:

- $1,000,000

- 15% of the company’s total assets, or

- 15% of outstanding shares shown on the most recent balance sheet.

So with all that in mind, here are my best practices recommendations for private companies that use equity compensation:

- Timing: Only grant stock options on the same day as meetings of the company’s board of directors (or authorized committee), where the board also makes a determination of the company’s value, even if it is only an affirmation of a previous valuation. All new employees who started work after the last meeting can receive awards together at the next meeting. Vesting can be shortened to coincide with anniversaries of each new employee’s start date.
- Live Meetings: Try to avoid making option awards by written consent. This used to be OK, but now it carries more risk (if one of your directors takes too long to send back a signed consent, the FMV may have changed in the meantime).
- Don’t Commit Stock Option Pricing Before the Board Meets.
- Employment offer letters should say the exercise price will be determined by the board of directors (or committee) at its next meeting. Otherwise you risk making an award with an exercise price (as promised in the offer) that’s different from the actual value of the underlying security when the award is approved by the board. This is not a big risk for private companies with slow-changing valuations, but public companies need to be careful about it.
- Put it in Writing: All stock option awards require a written stock option agreement signed by the company and the recipient.
- Include the Plan. Distribute a paper or electronic copy of the stock plan with each award, even if the recipient already has it.
- Include the Plan Description: If the company’s total awards will exceed $5 million in any rolling 12-month period, you must also distribute a plan description with each award. This will contain supplemental information beyond a summary of the plan.
- Monitor: Track all awards for (a) $100,000 annual vesting limit for incentive stock options and (b) Rule 701 compliance, and verify status before every award.Blue Sky: Have your law firm deal with any required state securities filings.

© 2013 by Robert G. Schwartz, Jr. All rights reserved Disclaimer: This summary is provided for educational and informational purposes only and is not legal advice. Any specific questions about these topics should be directed to an attorney.