Option Pool

An Option Pool is a reserved block of common stock authorized for issuance as equity compensation to employees, advisors, directors, and consultants. Standard option pools are structured under a Stock Incentive Plan or Equity Incentive Plan. The pool typically includes various equity instruments: Incentive Stock Options (ISOs, tax-advantaged for employees), Non-Qualified Stock Options (NSOs), Restricted Stock Awards (RSAs), and Restricted Stock Units (RSUs). Pool sizing and refresh is among the most negotiated cap table issues.

Stock incentive plan adoption

An option pool is ordinarily created by adopting a written stock incentive plan: (1) board approval of plan terms; (2) stockholder approval within 12 months before or after the plan is adopted, required for ISO qualification under § 422(b)(1); (3) plan terms, pool size, eligible recipients, types of awards, vesting parameters, expiration, transferability; (4) amendments, typically require board approval; some material amendments require stockholder approval. Plans typically allow flexibility, different vesting schedules, exercise prices, and award types within plan parameters.

ISO vs. NSO

Two principal option types: (1) Incentive Stock Options (ISOs), § 422; tax-advantaged for employees; no income tax at grant or exercise (subject to AMT); long-term capital gains on sale if holding period met (2 years from grant + 1 year from exercise); $100K limit on the grant-date value of ISO stock first exercisable in any calendar year; only employees eligible; 10-year maximum term; exercise price at least FMV at grant (for a holder of more than 10% of the voting power, at least 110% of FMV and a 5-year maximum term); (2) Non-Qualified Stock Options (NSOs), no special tax treatment; ordinary income on exercise (spread between FMV and exercise price); broader eligibility (employees, contractors, advisors, directors); fewer constraints. Most companies use mix of ISOs (for employees) and NSOs (for others).

Section 409A and exercise pricing

Section 409A imposes substantial penalties on options with exercise prices below fair market value at grant. Standard practice: (1) 409A valuation, independent valuation determining FMV at grant; (2) annual valuation at minimum; updates for material events; (3) presumption of reasonableness, an independent appraisal as of a date no more than 12 months before the grant is presumed reasonable, and the IRS can rebut the presumption only by showing the method or its application was grossly unreasonable; (4) penalties, if 409A violated, holder owes immediate income tax plus 20% additional tax plus interest.

Vesting schedules

Standard vesting: (1) 4-year vesting with 1-year cliff, most common; 25% vests after 12 months, then monthly vesting over remaining 36 months; (2) monthly vesting without cliff, for senior hires or specific arrangements; (3) milestone vesting, vesting tied to specific business milestones; less common; (4) accelerated vesting, provisions for acceleration on change of control (single-trigger or double-trigger). Founder vesting often parallels but with negotiated acceleration provisions.

Acceleration provisions

Common acceleration provisions: (1) single-trigger, full or partial vesting on change of control alone; common for founders; (2) double-trigger, full or partial vesting on change of control PLUS termination without cause within specified period (typically 12 months); standard for senior employees; (3) partial acceleration, typically 12 months of additional vesting; (4) full acceleration, all unvested options vest. Acceleration provisions are heavily negotiated; investors typically prefer no/minimal acceleration; founders/employees prefer full acceleration. Common compromise: double-trigger with full acceleration.

Pool sizing and refresh

Pool sizing decisions: (1) initial pool, set at or after incorporation; (2) expansion before a priced round, often requested by the lead investor; (3) refresh at later rounds; (4) pre-money vs. post-money, a pool created or enlarged in the pre-money valuation dilutes only the existing holders, while a post-money pool also dilutes the new investors. Over several rounds, pool expansions can add up to a meaningful share of founder dilution.

Rule 701 securities exemption

Rule 701 provides federal securities law exemption for compensatory grants by non-public companies: (1) offers, any amount may be offered, but option grants count as sales on the grant date; (2) 12-month sales limit, aggregate sales in any 12 months may not exceed the greatest of $1 million, 15% of total assets, or 15% of the outstanding class; (3) disclosure requirements, for grants exceeding $10M in any 12-month period, formal disclosure required; (4) relationship requirement, recipients must be employees, directors, consultants, or advisors. Rule 701 is the standard exemption for option grants; combined with state-law exemptions (typically in parallel), it covers most private-company option practice.

RSAs vs. RSUs

Other equity instruments often used alongside or instead of options: (1) Restricted Stock Awards (RSAs), actual stock issued at grant subject to vesting/forfeiture; common for founder grants; § 83(b) election available to elect taxation at grant; (2) Restricted Stock Units (RSUs), promise to issue stock at future date when vested; common at later-stage and public companies; income tax at vesting (no §83(b) available); (3) Phantom Equity, cash-settled rights tracking equity value. Each instrument has different tax, accounting, and economic implications.