Issuing Stock Options

October 27, 2020

By: Ryan M. Tharp and Colin A. Walker

Attracting and retaining key employees is one key to a company’s success. Equity incentives offer a way to incentivize high performance and reward loyalty. Stock options are one of the more common types of equity incentives. Below, Ryan Tharp of our corporate department discusses some of the requirements of granting stock options.

What are the legal requirements of issuing stock options?

Many growing businesses use equity to incentivize key employees. This is often in the form of stock options. When granting stock options, there are several requirements that must first be satisfied. The exact requirements depend on how the options are classified. Generally, the following requirements must be satisfied:

  1. The stock options must be granted pursuant to a written plan, which must usually be approved by the shareholders.
  2. The grant must be to bona fide service providers and approved by the company’s board of directors, unless the board has delegated that authority to another person or committee.
  3. The strike price for the stock options must not be less than the fair market value of the stock on the date of grant.

To determine the fair market value of a share of stock, the tax law imposes various requirements. Those requirements are slightly different depending on how the stock options are classified, but it basically boils down to this:

  • Use a valuation method that is reasonable considering the company’s business and stage. Common valuation methods include multiples of annual recurring revenue or EBITDA, public company comparable, book value or liquidation value, or so forth. 
  • Consider all information material to the value of the company. This would include, at minimum, the value of the company’s assets and of anticipated future cash-flows, recent arm’s length transactions involving the company’s stock, and other relevant factors.
  • Conduct the valuation in good faith. 

Unless there is a material change in the company, a valuation is generally good for 12 months.

Stock options can be complicated and stock option agreements need to be drafted carefully to achieve the desired result and to avoid misunderstandings and disputes. Competent counsel should be consulted before granting stock options or other types of equity incentives.