Launch Magazine - Fall 2007 - (Page 21) events (such as the sale of your company or your termination from the company). Do you need to add members to your founder group? If so, you should consider adopting an option plan and issuing options. Why options instead of stock grants? Stock grants can create an ugly problem: When stock is received at no price or a price less than fair market value, the recipient recognizes taxable ordinary income. Options generally avoid those problems, but beware of tax “gotchas” under new rules of Section 409A of the Internal Revenue Code, which require options to have exercise prices at or above the fair market value of their underlying shares. Because the fair market value for small private companies is usually unclear, companies must have “written reports” from “valuation experts” – which can be officers and directors in some cases, but are usually outside firms — to avoid unintended tax consequences. Section 409A is much maligned (and appropriately so) in the venture community. See more at http://www.feld.com/blog/archives/2005/12/409a_ government.html and the blog entries that follow. reserve more shares under your plan. Second, your cash flow and compensation structure. Cash and equity compensation have been described as two ends of a balloon. If, out of choice or necessity, your company squeezes the cash end of the balloon, reserve more shares under your plan. Third, your need for fresh talent. Fresh talent will be thirsty for upside in your company and it’s appropriate to give them incentive. If you need fresh talent, reserve more shares under your plan. What a Cap Table is Not Finally, understand what a Cap Table is not. A Cap Table is a mere summary that relies on other documents — stock purchase agreements, option agreements and the like, which I will refer to as “issuance documents” here. If there is a discrepancy between a Cap Table and issuance documents, issuance documents will control. And there are a number of other actions and considerations that should go along with issuance documents. All issuance documents should be approved by your board of directors. Stock purchase agreements should have stock certificates that relate to them. Stock certificates should be tracked in a stock ledger — a sort of history about what has happened to each stock certificate. You should pay appropriate attention to tax issues and securities exemption issues in connection with issuance documents. Not handling these sort of issues appropriately is perhaps the biggest problem with young companies and is worthy of a separate article. Why do you need an option plan instead of just stock options themselves? You need an option plan to grant incentive stock options (ISOs), a kind of tax-favorable option. See more about tax treatment of ISOs at http://www. investorwords.com/2396/incentive_stock_option. html. While the merits and advantages of ISOs are debatable, your target employees are expecting ISOs, so you should strongly consider providing them as a matter of course. Take care to adopt an ISO plan appropriately — Internal Revenue Service rules require approval not only from your board of directors but also from your shareholders. Conclusion While modeling a Cap Table is not very hard, handling all of the issues and paperwork that goes along with it is. It is also expensive both in terms of legal costs and drain on management’s time and attention. So keep your Cap Table and your capitalization simple. Document it carefully. Do it right the first time — it is hard to undo or change. Then, keep your Cap Table up to date as a resource to summarize what you’ve done. The Cap Table is an extremely important document that can either help or severely hinder your ability to raise money. Doing it right will show your investors a story documenting your equity issuances and build their trust in you, even if they do not agree with all of your capitalization decisions and assessments. Best of luck! $ Brent Hawkins is a partner at the law firm of Bennett Tueller Johnson & Deere, P where his practice focuses on issues .C., relating to the formation, financing, governance, strategic transactions, and sale of emerging and mid-size companies. Click here for the HTML version of this article on launchutah.com. What effect does your option plan have on the price an investor will pay for your stock? Sadly, sophisticated investors will “price around” your reserved plan share by including them in the denominator of the pricing calculation referenced above. Why? Notwithstanding some compelling reasons to the contrary, that’s just the way it is, and arguing strongly against the “price around” will make you seem out of touch with reality. But learn a lesson here: While your option plan should accommodate your immediate option needs, adopting too big a plan will only dilute you. What percentage of your capitalization should you reserve under your plan? Typically 12 percent 25 percent. Where along that spectrum? It depends. Consider three things: First, the size of your company. If you are a newly formed and unproven company, launch fall 21 http://www.feld.com/blog/archives/2005/12/409a_government.html http://www.feld.com/blog/archives/2005/12/409a_government.html http://www.investorwords.com/2396/incentive_stock_option.html http://www.investorwords.com/2396/incentive_stock_option.html http://www.investorwords.com/2396/incentive_stock_option.html http://www.launchutah.com/article-feature-q32007.php
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