Avoiding Stock Option Regrets Before Series A
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
Around a Series A round, opportunities to consider using stock options increase as hiring plans for business expansion take shape. The company wants to bring in talented engineers and business leaders, reward the members who have supported the business since its founding, and prepare performance-linked incentives with a future IPO or M&A in mind. All of these are positive motives.
Stock options are stock acquisition rights, not a system for immediately delivering shares themselves. The issuance and grant of the rights, the subsequent exercise of the rights, and the sale of the acquired shares are each separate procedures. If the initial design is wrong, it can affect future capital policy, recruiting, and discussions with investors in the next financing round. Stock options are a powerful hiring tool and, at the same time, part of the company's capital policy itself.
Especially around a Series A, the immediate decision of "who gets how many" is not enough. You need to treat future hiring plans, fairness with existing members, the dilution borne by existing shareholders, and accountability in the next round and in the exit strategy as one continuous set of issues.
Many companies at this stage are unsure whether to hire a dedicated in-house lawyer as a fixed cost. However, designing a stock option plan is less a matter of routine administrative work and more a task that requires weighty decisions at important business milestones. By using outside attorneys like members of an in-house legal department and setting up a structure to review the capitalization table, hiring plan and issuance procedures together, the company can receive legal support when it needs it. Rather than expanding the administrative structure in advance as a fixed cost, the company can also consider increasing outside support during periods when important decisions are concentrated.
Considering the Pool Size in Line with the Hiring Plan
The first item to consider when introducing stock options is the size of the pool to set aside. While a company might tentatively assume around 10 percent for discussion purposes, the appropriate level depends on each company's business plan.
The benchmark for this consideration is the plan for what kinds of roles and positions will be hired over the 12 to 24 months or so after the Series A financing. The level of incentive that should be offered varies depending on the role of the person the company wants to hire, such as a chief technology officer, a head of business or a product manager.
Additional grants to existing members who have supported the business since its founding on low compensation also come into view. How to design the balance of treatment between the contributions of early members and new executives who join after the financing at commensurate compensation levels goes to the core of building the organization. A larger pool is not necessarily better; an excessive pool leads to unnecessarily diluting existing shareholders' stakes. On the other hand, if the pool is too small, the company will not be able to offer sufficient incentives when recruiting. It is important to calculate the size by comparing the hiring plan against the capitalization table.
Designing Vesting and Exercise Conditions
In discussions about plan design, the grant percentage tends to be the first topic raised, but in practice the details of the grant conditions influence future decisions even more.
Vesting design is particularly important. Possible designs include whether rights vest immediately upon joining, or, for example, vest in stages over four years with a cliff period during which no vesting occurs for the first year. The company should also decide in advance how unvested and unexercised portions will lapse upon departure and within how many days after departure exercise will be permitted. Furthermore, the character of the plan changes significantly depending on whether it includes a clause accelerating the vesting of unvested portions in the event of a future M&A and whether exercise is permitted before an IPO.
These conditions may appear to be formalities at the time of grant, but they greatly affect management's options when officers or employees leave, when an M&A approach is received, or when responding to questions from investors in the next financing. A stock acquisition rights allotment agreement is not merely a formal contractual document; it functions as an internal rule governing future organizational management.
Checking the Tax-Qualified Requirements and Issuance Procedures
With tax-qualified stock options, by satisfying certain requirements set out in the Act on Special Measures Concerning Taxation, taxation of the economic benefit at the time of exercise is deferred until the shares are sold, and the gain is taxed as capital gains at the time of sale. This is a major tax advantage for the members who receive the rights.
However, to qualify for tax-qualified treatment, multiple requirements must be strictly satisfied, including the scope of eligible grantees, the exercise period and the exercise price. What you want to avoid in practice is a case where the plan was designed with the intention of being tax-qualified, but a later check reveals that the requirements were not met. In particular, check the individual conditions for grants to outside technical collaborators, the structuring of trust-type stock options, and grants to non-residents. While coordination with a tax accountant on tax matters is a given, it is important to examine early, from a legal perspective, the procedures for issuing stock acquisition rights under the Companies Act and consistency with existing investment agreements.
Pre-Money and Post-Money Pools and Dilution Negotiations
A point that tends to become an issue in Series A investment negotiations is whether the stock option pool is included in the number of shares before the investment or added after the investment. If the price per share is calculated by including the pool in the fully diluted share count before the investment, the dilution from setting up the pool is borne by the existing shareholders. By contrast, if the pool is set up after the investment, the new investors also share in the dilution. Which design is adopted, and who effectively bears the dilution, is determined by the definitions in the term sheet and the formula for calculating the share price.
This difference in treatment directly affects how the presented valuation should be understood. Even if the nominal pre-money valuation looks high, if it assumes a large pool set up before the investment, the actual ownership percentage of the founders and existing shareholders may fall more than expected. Therefore, when receiving a term sheet from an investor, it is essential to review the valuation, the amount raised, and the timing and size of the stock option pool as a single set of economic terms.
Recording the Reasons for Grants and Building an Operating Structure
At the time of grant, stock options are operated as an internal reward system, but in due diligence in the next round or a future M&A, the history of the grants will be examined, such as "why that person was allotted that number" and "how balance with other officers and employees was judged."
For this reason, keep an internal decision memo recording the expected role of each grantee and the balance with past contributions and compensation levels. If, after recording the statutory matters in the minutes of the required shareholders' meetings and board of directors meetings, the company also keeps a decision memo supporting what management based its decisions on, the burden of explanation later can be reduced. In addition, tell job candidates the exercise price and vesting conditions along with an approximate grant percentage. Also explain the treatment upon departure and the outlook for future dilution before they join.
Furthermore, it is important to look not only at plan design but also at building an ongoing management structure. Make it possible to confirm to whom, when and how many options were granted, whether the necessary resolutions and allotment agreements have been completed, and whether the rights of departed employees have been processed in accordance with the conditions. Manage this by reconciling the stock acquisition rights register with the minutes, agreements and management spreadsheet. When the number of grantees grows to several dozen, management errors become more likely, and in future reviews, defects in contract documents or resolutions may be pointed out, causing the company to scramble to fix them.
LegalAgent supports startups with capital policy and stock option design. We also review investment agreements and shareholders' agreements together, and we have a structure in which AI and attorneys work together to respond quickly. AI is used to quickly organize existing capitalization tables and grant lists, cross-check clauses in investment agreements, and prepare drafts. On that basis, attorneys discuss with management who should receive what level of grant. We confirm workable methods in light of tax law, the Companies Act and the terms of the investment agreements. We balance multiple demands, namely promoting hiring, limiting dilution and maintaining discipline that can withstand future reviews, and consider the options the company can adopt.
If you want to comprehensively review your stock option pool, grant conditions and negotiation strategy with investors as you approach Series A, we provide support, including within a scope that can be handled for a fixed fee, with an initial response within one business day as a rule. Please see the following page for details of our support.
Frequently asked questions
Why should stock options be designed before a Series A?
Because when the valuation rises at a Series A, the exercise price also rises, and even with the same pool the benefit to grantees becomes smaller. Also, because the size of the pool is a negotiation point in a Series A, having a policy in place beforehand makes negotiations easier to move forward.
Should the stock option pool be created before or after the investment?
Which one you choose changes whether the dilution is borne by the founders and existing shareholders alone or shared with the new investors as well. It is an issue on which the premise should be confirmed at the term sheet stage.
What happens if stock options are granted by verbal promise?
Disputes over the terms tend to arise later, and this is also flagged as a problem in Series A legal due diligence. A promise to grant needs to be formalized as an official issuance accompanied by the necessary resolutions and contracts.
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