How do you determine stock options for your US employees?

15 Nov 2018

By Tosin Agbabiaka

1. Retain advisers: Above all else, tax and legal advisers should be engaged early on to help you think this through and to understand how to establish and maintain a stock option plan for your US employees.

2. Employee expectation: US employees who are working for a start-up (even a ‘mature’ one), will typically expect some form of their compensation to be in equity (whether this is a direct issuance of shares or, more commonly, stock options).

3. Keep it simple: However, given the ease with which US employees can leave employment and the administrational burden of managing a large option plan at the outset, we would suggest that with your first US hires, you only offer equity for your senior or key roles.

4. Use your existing incentivization framework: You should have an existing framework which sets out how you, as a company, think about granting options to employees. There is no ‘right’ way to do this (and much has been written and continues to be written on this topic). Once you have an objective calculation methodology, we suggest that you use the same principles to build a US-focused option framework.

5. Have a separate option plan for your US employees: You will likely need a separate option plan for your US employees and, while it should take account of your company’s overall remuneration philosophy, it may also include nuances for the local market (eg. what equity stake do other US country heads get offered in similar size/ stage companies; how are leavers treated; what does a vesting schedule look like). Inequalities may creep in from location to location, and yet this flexibility is something you will need to be comfortable with in order to hire the best talent.

6. 409A Valuation: In the US, it is an absolute prerequisite for the company to have a 409A Valuation at the time of each option grant. A 409A Valuation is simply a fair-market appraisal of the stock of your parent company. We recommend you do this externally and pay the $2-$5k for the valuation. This will ensure that any challenges to it from the IRS, require the IRS to do the leg-work to disprove the methodology applied by the external valuation firm.

Top tips:

a. Synchronize valuations (conducted in the US and the other jurisdictions) at the outset to avoid complicated retrospective synchronizations of separate plans.

b. UK and US tax authorities, in particular, don’t have a similar approach to assessing what the exercise price of the options should be. You will need to understand how you can make pricing ‘equal’ – are you going to have different exercise prices in simultaneous grants of your options to your UK and US employees and if so, does this impact the number of options you are willing to grant an employee?

c. Have excellent communication with your employees. Explain how the grant and exercise process works, what happens if they leave and what happens if there is an exit. Be mindful that options are only truly valuable if employees understand how they work.

How EMI Works in the UK

Under the EMI scheme, a company can “self-assess” to set up the plan and HMRC should be notified whenever options are granted. There are annual limits for participants and a restriction on the total value of options in the pool. The exercise price must be agreed with HMRC in advance to ensure that the tax breaks are achieved. The exercise price for ordinary shares (typically the share class for options) can be at a discount to the share price for preferred shares and this discount can be up to 70% or more. The valuation methodology and calculations are normally sent to HMRC as part of a short one to two-page letter. HMRC valuations are typically refreshed after a funding round or if company performance materially changes. HMRC valuations can only be agreed when new options are to be issued—HMRC will not do “speculative” exercises to try and gauge a likely price.

How “Stock Options” work in the US

There are two main categories for option plans in the US; ISO (Incentive Stock Options) and NSOs (Non-qualified Stock Options). The ISO is the closest equivalent to the UK EMI scheme. The differences in both US structures are laid out below:

For an overview of differences between ISO (Incentive Stock Options) and NSO (Non-qualified Stock Options), download the Question the Questions report below and check out pages 107-108.

“ Europeans might be averse to giving options, while in the US, employees expect a piece of the action and they know how to calculate the value of options. It’s a major factor for the people you are hiring in the US…and if it’s a not a major factor, you might be hiring the wrong people here!” – Ari Salonen, Midaxo [MIXADO LOGO]