📄 Stock Option Plans

🎉 Happy Friday, funds family!

Equity compensation is one of the most important tools a company has to attract and retain talent. Naturally, it is a significant topic for companies and their investors because how equity is structured, granted, and taxed affects employee / consultant incentives, cap table management, and ultimately the value that founders and investors realize at exit.

An employee stock option plan (ESOP) is a formal plan under which the company grants employees (or consultants, via non-qualified stock options )the right to purchase shares at a fixed price (aka the strike price) over time, subject to vesting. The goal is to align employee incentives with the company's long-term success. Employees benefit only if the stock price exceeds the strike price. But how that equity is structured, and particularly how it is taxed, matters enormously for both the company, the employee, and ultimately, the investors.

➡️ What exactly is a stock option and how does it differ from a stock grant?

A stock option is a right (not an obligation) to purchase shares at a set price at a later date. The option itself has no economic value until the stock price exceeds the 📄 strike price. When it does, that difference is called the "spread." Note that an option typically also does not have any governance or control rights because it does not constitute a voting share.

A restricted stock award (RSA) is different. The employee actually receives shares today, typically subject to a vesting schedule and a company repurchase right. RSAs are more common for founders (who receive them at formation) than for employees hired later. Restricted stock units (RSUs) are a third structure, which at a high-level promise to deliver shares at a future date and are more common at later stages or in public companies.

➡️ What are the two types of stock options?

There are two main tax-law structures of stock options:

• Incentive Stock Options (ISOs): available only to U.S. employees (not contractors), subject to specific IRS requirements, and potentially eligible for favorable long-term capital gains treatment if holding period requirements are met. ISOs are the standard form for startup employees.

• Non-Qualified Stock Options (NSOs): available to employees, contractors, and advisors. Exercise of an NSO is a taxable event at ordinary income rates on the spread. NSOs are often used for grants above the annual ISO limit or for non-employees.

ISO treatment is generally more favorable for the employee, but with an important caveat: the spread on an ISO at exercise is a preference item for what’s called Alternative Minimum Tax (AMT) purposes, which can create a tax liability even before the employee sells any shares. This AMT exposure is a real issue for employees at high-valuation companies and should be understood before exercise.

➡️ How do option pools work?

The company establishes an equity incentive plan that reserves a pool of shares for future grants. This option pool is typically sized at ~10–15% of the company's fully diluted share count at initial formation, and is often increased as a condition of a priced financing round. Key mechanics:

• Ungranted options in the pool appear on the 📄 The Cap Table as reserved shares but do not dilute existing holders until granted (but count towards the “fully-diluted capitalization” number).

• Investors typically want an option pool refresh as part of a priced round, sized to cover expected hires for the next ~12–18 months.

• The timing of the refresh matters significantly: if done pre-money (before the round is priced), it dilutes founders before the new investor comes in; if done post-money, the dilution is shared proportionally across all holders. It is more common to do it as post-money.

➡️ What happens to options in an acquisition?

In an acquisition, stock options are typically treated in one of three ways:

• Acceleration: options vest early upon the change of control, either single trigger (automatic upon the sale) or 📄 double trigger double trigger (requires both the sale and a termination event).

• Assumption: the acquirer assumes the option plan and converts options into options on the acquirer's stock on adjusted terms.

• Cashout: the acquirer pays out the intrinsic value of vested in-the-money options at closing.

Which treatment applies is negotiated in the acquisition agreement, and the outcome can make a significant difference for employees with large unvested positions. Investors approving an acquisition should understand the option treatment before voting.

➡️ The practical takeaway

For the company:

1. Establish a formal equity incentive plan early, with proper board approval and legal documentation.

2. Use ISOs for employees and NSOs for contractors, advisors, and grants above the ISO annual limit.

3. Educate employees on the tax implications of exercising options, particularly AMT risk for ISOs and the holding period requirements for capital gains treatment.

4. Keep the option pool sized appropriately relative to hiring plans, and model the dilution from any pool increase before agreeing to it in a term sheet.

For the investor:

1. Review the equity plan as part of diligence: how large is the option pool, how much is issued versus reserved, and are the plan documents in order?

2. Understand the vesting schedules for key employees, not just founders. Employee departures at critical junctures can be destabilizing.

3. Pay close attention to option pool refresh provisions in term sheets and model the dilution impact before signing.

4. For acquisitions, understand how the option plan will be treated (assumption, acceleration, or cashout) before approving the deal.

Thanks for reading, everyone!

Have a great weekend! 🙌

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This may be considered attorney advertising.