Option Exercise Checklist for Founders

Shriram Bhashyam
Aug 27th, 2015
So you've made the leap and founded a company. Awesome. You've incorporated and got your corporate starter kit in order (bylaws, stock plan, forms of equity docs, etc.). Sweet. Most importantly, you've convinced talented people to join you on this wild ride to build something amazing. Hearty congrats. Now it's been a year and your first hires, the ones who helped you ship your MVP and gain traction, are exercising their options. We recently experienced this at EquityZen, and while it's incredibly fulfilling to see your team members excited about exercising their options and owning their shares, it's also a bit daunting. Here's a checklist--based on our experience--to make sure you're covering your bases for the company and your employees.

This checklist assumes that Incentive Stock Options, or ISOs, (more info on that here) are being exercised by a current employee (there are a few tax wrinkles for NSOs and best practices for former employees that we don't address here).

o        Review the exercise notice and make sure it's been properly completed. Be sure to double check the type of options being exercised (ISO/NSO).

o        Confirm that the options being exercised have actually vested (or are eligible for early exercise). Vesting is typically over a four year schedule with a one year cliff (before which zero shares will have vested). Once the cliff is crossed, 25% of the grant will have vested, and there after the option will vest in equal installments (usually monthly, but sometimes quarterly) over the remaining three years. Keep in mind that it's possible for a fractional number of shares to vest at the cliff and/or on the following monthly schedule. In that case, you can round down for the vesting at the cliff and monthly vest amount, and then make up the sum of the fractional shares in month 48.

o        Now's also a good time to review your records to ensure you have the whole story of the employee's stock: the board resolution authorizing the grant, the grant document, and your capitalization table (here's a handy excel template we made for cap tables).

o        Confirm compliance with Rule 701. Rule 701 is an exemption from registration of securities for equity awards granted pursuant to equity compensation plans. Under Rule 701, aggregate sales price of securities sold or options granted cannot exceed, in any 12 month period, the greater of:

                        i.         $1 million,
                       ii.         15% of the company's total assets (as measured against the company's most recent fiscal year-end balance sheet), or
                     iii.         15% of the outstanding amount of class of securities being offered and sold in reliance on the rule (as measured against the company's most recent fiscal year-end balance sheet).

o        Confirm the company does not need to make a new fair market valuation assessment. More info on that here and here.

o        Countersign the exercise notice and make sure the company and the employee execute a stock option exercise agreement, stock restrictions agreement, or equivalent. This is an agreement that governs the ownership of shares the employee now owns.

o        Provide disclosure to the employee about risks and restrictions associated with purchasing private company shares (not required but worth considering).

o        Update the company’s cap table to reflect the exercise.

o        Have company counsel prepare a stock certificate (or if the company uses a book entry system, make sure the exercise is properly recorded on the ledger).

o        File IRS Form 3921 (by February 28 of the year following exercise) and provide a copy of the form to the employee (by January 31 of the year following exercise).

o        Check whether any "blue sky" filings are required. "Blue Sky" laws are state securities laws and can require notice filings in connection with the exercise of options. Check whether the state of residence of the employee requires such a filing. Generally, these filings are required within 15 days of sale in the state.

This post is for informative purposes only and does not constitute tax or legal advice. Consult your legal or tax advisor for advice specific to your circumstances. Links to websites outside of our domain do not constitute an approval or endorsement of the content on those websites.
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