Designing Stock Options as Capital Policy: How to Think About the Pool and Who Receives Grants
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
Around a Series A, companies increasingly find themselves considering, at the same time, the incentive terms to offer new hiring candidates and additional grants to existing members who have contributed since the early days. The precision of the plan design is also tested when investors ask for the stock option pool to be expanded, or when the company must decide how to handle unexercised options left behind by departing employees and unvested options at the time of an acquisition.
That said, I feel it is quite risky to view stock options solely as a recruiting tool. A stock option is itself a right to acquire shares in the future, and once granted, it affects not only the ownership percentages of the founders and existing shareholders but even prospective future buyers. If the selection of grantees or the allocation terms are designed poorly, the arrangement may appear to work conveniently at the moment of hiring, yet the company may later find itself unable to give a reasonable explanation in the due diligence for its next financing round or for a merger or acquisition (M&A).
The Stock Option Pool as a Dilution Budget
Before debating what percentage to reserve for the pool, you first need to clearly align the share count used as the denominator and the reference date. Whether the denominator is only the total number of issued shares, or the fully diluted share count including already-issued stock acquisition rights and the unissued pool, changes the substantive meaning of the same "10 percent." You should also confirm how treasury shares and existing stock options are counted, and the capitalization table must state clearly whether the percentage is based on the pre-investment (pre-money) or post-investment (post-money) figure.
A stock option pool has several aspects. For the company, it is a resource for future hiring; for existing shareholders, it is a dilution budget that thins their holdings. From the founders' perspective, it is a significant management decision about how much of their own stake to share with future colleagues; for investors, it is both the hiring budget the portfolio company needs in order to grow and an economic term of the dilution they themselves will bear.
For example, if the Series A investment terms (term sheet) assume that a certain percentage pool is reserved before the investment, the real ownership percentages of the founders and existing shareholders may fall further than expected, even if the headline pre-money valuation looks high. On the other hand, if the pool is set up after the investment closes, the new investors will also share in that dilution. Who bears the dilution is a point for negotiation in the investment terms.
The size of the pool should be considered based on the hiring plan up to the next round. You should also confirm the number of options needed to hire executives and how dilution is to be shared with investors. What I particularly want to caution against here is taking comfort merely in the fact that a pool has been set up. Reserving a pool and being able to allocate it appropriately are separate issues. If you create only an oversized pool without deciding to whom, when, at what level, and on what terms grants will be made, future grant decisions tend to become ad hoc.
Grants from the pool involve the company's decision criteria and the prescribed resolutions. The basic way to prevent confusion in practice is to understand the pool as a capital-policy budget through which management allocates the shareholders' equity to the future organization.
What Hiring Candidates Are Told Versus the Reality of the Cap Table
In recruiting, companies often explain to candidates, "We will grant you the equivalent of X percent of our shares." When presenting a percentage, you should also convey the assumptions behind the calculation.
This is because the value of a stock option is not determined solely by the ownership percentage figure. The economic benefit a grantee actually receives depends heavily on the exercise price per share, the fair market value at the time of grant, dilution from subsequent financings, the vesting period and conditions, the treatment of the rights upon departure, the expected time to an IPO or M&A, whether the options are tax-qualified, and the funding burden of taxes and payment on exercise.
Even for the same "0.5 percent equivalent" grant, the value perceived by the holder differs fundamentally between a design with a low exercise price, satisfaction of the tax-qualification requirements, reasonable vesting, and a certain post-departure exercise grace period, and a design with a high exercise price, non-qualified tax treatment, and immediate forfeiture or forced immediate exercise upon departure. Note also that a long vesting period does not always work in the recipient's favor. If, in a rush to hire, the company conveys only an overly optimistic outlook, this can lead to distrust after joining, such as "dilution progressed more than I expected," "the post-departure exercise window was too short and I lost my rights," "an unexpected tax burden arose," or "the treatment in the M&A differed from what I was told beforehand."
At the same time, it is not realistic to explain every detailed legal and tax provision to a hiring candidate. The practical approach is to decide in advance the scope of matters the company should explain, and to explain the exercise price, vesting conditions, and points requiring tax confirmation in plain language that does not create misunderstanding.
Here too, the underlying fact is that a stock option is a capital-policy right directly linked to future shares. If there are discrepancies among the recruiting materials, the offer letter, the allotment agreement, and internal explanatory materials, the company will struggle to explain itself in later disputes or in due diligence.
Criteria for Selecting Grantees
The question of who should receive stock options is a difficult management decision. Should the company allocate generously to early founding members, give larger grants to core executives who join after the Series A, spread grants broadly and thinly across all employees, or focus on specific core engineers and business leaders? The appropriate allocation differs depending on each company's business policy.
However, deciding grantees solely on external criteria such as job title or order of joining is a dangerous approach. Stock options do have an aspect of rewarding past achievements, but their real purpose is to secure a commitment to increasing corporate value into the future. The wish to reward those who supported the company through its early hardships is natural, but from a capital-policy perspective, you must evaluate together the expected contribution to future business growth, the need for retention, and fairness within the company.
For example, if the company makes large grants to executive candidates brought in from outside after the Series A without making additional grants to members who have supported the company on low salaries since the early days, this can undermine the organization's sense of unity and fairness. On the other hand, for key positions where competition to hire is intense, such as chief financial officer (CFO), business leader, or head of engineering, the reality is that it may be difficult even to hire without offering a commensurate stock option. This allocation balance cannot be resolved by HR logic alone, nor by the formal criteria of legal or capital policy alone.
When deciding on grantees, it is useful to put into words what role the person will play in increasing future corporate value, how the ratio between cash compensation and stock options was positioned, and how the balance with existing members was worked out. The reasons for judging that a given grant level was necessary in light of the competitive hiring market, and how the company expects to treat the options in the event of departure or a change in role, should also be organized at the stage of the grant decision.
Vesting as a Capital-Policy Safety Mechanism
Vesting (conditions for the rights to become exercisable) lies at the core of stock option term design. Vesting is a mechanism under which granted rights become vested in stages, conditioned on continued service for a certain period or on achievement of prescribed performance targets. In practice, a common design has the rights vest monthly or annually over four years, with a "one-year cliff" under which nothing vests during the first year.
Vesting is often seen as an HR mechanism that encourages long-term commitment from hiring candidates. It certainly has that function, but from a capital-policy perspective it is nothing other than a safety mechanism to prevent an excessive stake from flowing out to someone who leaves early.
If the company adopted a design under which all rights vest immediately upon joining and remain intact even if the person leaves right afterward, future share value would accrue to the departed person without any link to continued service. Except for special cases where the person had already provided substantial value at the time of joining, linking the progress of vesting to involvement in the company's continued growth is easier to justify to existing shareholders and future investors.
On the other hand, if vesting conditions are set too strictly, their appeal as an incentive in the hiring market is lost. Presenting provisions that are one-sidedly favorable to the company to a talented executive candidate who already has high market value may be perceived as excessive risk and put the company at a disadvantage in the competition for talent.
Vesting provisions should be designed in light of the recipient's role and the risk they take on when joining. The company should also be able to explain differences in terms compared with existing members. At the same time, care should be taken so that the design philosophy behind vesting does not vary from person to person within the company. Even when exceptional terms are granted in an individual hiring negotiation, each exception increases the burden of explanation in future financings and M&A, so it is important to leave a written record of the business reasons for permitting that exception.
Settling the Rules for Departure Before Anyone Leaves
The area of stock option practice most prone to disputes is the treatment of rights upon departure. Do unvested rights automatically lapse upon departure? Can the holder keep vested but unexercised options? Within how many days after departure must exercise be completed? Should voluntary resignation and departure for company reasons be treated differently? How should cases involving disloyal conduct, such as disciplinary dismissal or breach of confidentiality obligations, be handled? And how should the treatment of officers leaving office differ from that of employees leaving employment?
Once a departure has actually occurred, it becomes difficult to reach agreement if you only start considering these issues then. When someone leaves with grievances against the company, the conditions for exercising stock options readily become a point of emotional conflict, and where the departing person is familiar with trade secrets or important information, disputes also tend to arise in connection with non-compete and confidentiality obligations. On the other hand, if the company unilaterally imposes harsh forfeiture conditions, it will also plant distrust and a sense of unfairness among the existing members who remain.
The design of departure treatment is not merely a legal contract provision; it is also an important message about how the organization is run. As one example, a design that requires a holder who resigns voluntarily to exercise within a set period, such as "within 90 days after departure," aims to limit the capital-policy uncertainty of unexercised rights lingering for a long time after departure. For the departing person, it creates the burden of arranging the exercise funds within a short period.
It is also common to include a provision causing the rights to lapse upon disciplinary dismissal or a serious breach of obligations, but if the triggering requirements are unclear, the company runs the risk of a legal dispute on the ground that it abused its discretion. As for the treatment of rights on departure, it goes without saying that this should be clearly set out in the terms of issue of the stock acquisition rights and the allotment agreement; it is also important to work out in advance how carefully the company will explain it at the time of grant and when presenting hiring terms.
Treatment of Unvested Options in M&A
When considering treatment in an acquisition, first confirm the legal structure of the transaction precisely. In an acquisition by share transfer, the issuing company itself continues to exist, so the buyer does not automatically assume an obligation to take over the stock options or to buy them out for cash. Where stock acquisition rights of the buyer are delivered as substitutes in connection with a merger or similar transaction, confirm compliance with the reorganization procedures under the Companies Act and the delivery terms.
When proceeding with exercise before the transaction, acquisition by the issuing company of its own stock acquisition rights with payment of consideration, or accelerated vesting of all unvested options, confirm the provisions of the terms of issue and the allotment agreement, whether individual consent of the holders is required, and the prescribed procedures under the Companies Act. Note also that cash consideration delivered upon the company's acquisition of stock acquisition rights is not necessarily treated as a tax-qualified capital gain on shares.
In practice, a point that tends to generate particularly heated debate is the "acceleration" provision. This refers to a design under which, triggered by certain events such as an acquisition or merger, some or all of the unvested options that would otherwise vest in the future vest immediately.
Acceleration has a clear purpose: to prevent the unfairness of excluding members who contributed to the sale or exit of the company from the economic return merely because their options had not yet vested at the time of the transaction.
On the other hand, if acceleration is uniformly and broadly permitted, it becomes a factor affecting the buyer's allocation of the purchase price and its future personnel costs. In addition, for executives and employees whom the buyer wants to remain as key persons for a certain period after the acquisition, having all rights vest at the moment of the transaction may significantly weaken the post-acquisition retention effect.
In practice, besides a "single trigger," under which options vest unconditionally upon completion of the M&A itself, a "double trigger" design is also used, under which options vest only when completion of the M&A is combined with an event such as dismissal or a change in role within a certain period after the transaction. Note that even if the exercise timing is brought forward contractually, to receive tax-qualified treatment the requirements such as "two years having elapsed since the grant resolution" and the annual exercise limit must also be met. What condition setting is optimal depends on the company's hiring policy, the profile of the expected buyer, and the importance of the core members. Here too, stock options function as an important capital-policy device that determines who will be left with what economic fruits in future M&A negotiations.
Requirements for Maintaining Tax-Qualified Stock Options
In the Japanese startup scene, tax-qualified stock options are widely used. Tax-qualified stock options are a system under which, provided prescribed legal requirements are met, employment income taxation on the economic benefit at the time of exercise is deferred, and taxation is instead imposed as capital gains when the shares are sold in the future. Comparing grants made free of charge to residents of Japan, employment income in the non-qualified case is subject to progressive rates, and the maximum combined national income tax and local inhabitant tax rate, excluding the special reconstruction income tax, is 55 percent. The basic tax rate on capital gains from shares in the qualified case is 20.315 percent, but the actual difference varies depending on the individual's income and additional taxation aimed at high-income earners.
However, tax-qualified stock options are not such a simple system that writing "tax-qualified" in the agreement makes them so. Multiple requirements prescribed by the Act on Special Measures Concerning Taxation, such as the eligibility of grantees, the exercise period, the exercise price per share, and the cap on the annual aggregate exercise price, must be satisfied without omission on an ongoing basis.
In the FY2024 tax reform, the cap on the annual aggregate exercise price was raised for stock options granted by certain stock companies, and a new option was also introduced under which the issuing company itself keeps restricted shares in segregated custody by a prescribed method. In addition, for grants to highly skilled external talent, the eligibility requirements and certification procedures have been revised on the premise of the plan certification system of the Ministry of Economy, Trade and Industry.
In particular, when granting to outsourcing contractors, non-residents, or persons positioned just before or after becoming an officer, you must not put off confirming tax qualification. This is because whether the qualification requirements can be met depends fundamentally on the person's legal status and the nature of the contractual relationship.
Furthermore, even if the company believes it designed the options to meet the tax-qualification requirements on paper, if actual operation departs from the statutory requirements, it may result in qualification being denied in a later tax audit or similar. Always check that the terms of issue, the allotment agreement, and the actual exercise procedures remain consistent with one another.
Collaboration with tax accountants is fundamental for tax questions, but the issuance resolutions and registration procedures under the Companies Act, consistency with the investment agreement and the shareholders' agreement, drafting the allotment agreement, and cross-checking against internal explanatory materials are areas that should be settled at an early stage from a corporate legal perspective.
Points to Note When Granting to Contractors and Advisors
In startups, we frequently receive requests to grant stock options to outside collaborators such as outsourcing contractors and advisors. It is a natural idea to want to provide an equity incentive to people who are not officers or employees but are deeply involved in the company's growth, such as technical advisors, business development advisors, and external specialists.
However, grants to outsourcing contractors require more careful design than ordinary grants to officers and employees. The first thing to confirm is whether the grant can qualify for tax-qualified stock option treatment. A special system for highly skilled external talent does exist, but merely having concluded a service agreement does not automatically make a grant qualified. You should confirm that the company-side requirements, the individual eligibility requirements of the grantee, and the prior certification procedures with the Ministry of Economy, Trade and Industry are accurately satisfied.
Next, consider whether the specific services provided under the service agreement reasonably correspond to the consideration for and reasons behind granting the stock options. In cases where an excessive stock option is granted to an advisor who in reality does almost no work, it becomes difficult to give investors and prospective buyers a reasonable explanation in a later financing or M&A.
Further, unlike employees, outsourcing contractors are not subject to direction and control or to the discipline of continued service based on work rules or an employment relationship. For this reason, ensure that both the service agreement and the allotment agreement work together without inconsistency regarding the securing of performance of confidentiality and non-compete obligations and the forfeiture of stock options upon termination of the contract.
Allocating Among Cash Compensation, Shares, and Stock Options
In discussions of incentive design, attention tends to focus only on the grant percentage. However, management has a variety of tools available, such as ordinary cash salary, performance-linked bonuses, and the delivery of actual shares, and what is tested is the overall design of how these are combined and in what proportions.
The economic value of a stock option depends on the future share value, the exercise price, and the conditions under which the options can be exercised and the shares sold. Stock options are therefore highly compatible with core personnel who commit to the company's growth over the medium to long term. On the other hand, as a reward for short-term results at hand or as consideration for achieving specific, clearly defined tasks, evaluation through cash compensation may be more direct and easier to accept.
Where stock options are used for an external specialist supporting a specific short-term project in order to hold down cash outlays, it is important to carefully assess how much that person will actually be involved in increasing corporate value over the medium to long term. If it is perceived that stock options were merely used to fill in for consideration for short-term services, the appropriateness of the arrangement as capital policy may be called into question.
When encouraging existing members to stay, the company should also be able to explain the allocation relative to cash compensation. If the company offers only stock options at a juncture when it really ought to raise cash salaries, there is a risk that recipients will perceive it as a postponement of improvements to their compensation. On the other hand, if the purpose is to share long-term results with colleagues who will create future corporate value together, stock options work effectively.
Note that it is not legally permissible to replace the wage payment obligations imposed by Article 24 of the Labor Standards Act and other provisions with grants of stock options alone. For outside collaborators as well, the obligation to pay consideration for services and the payment due date must be separately and properly confirmed in accordance with the laws and contract provisions applicable to the transaction, such as the Act on Ensuring Proper Transactions with Small and Medium-sized Entrustees (Torihiki Tekiseika Act) and the Act on Ensuring Proper Transactions Involving Specified Entrusted Business Operators (Freelance Act).
Explainability in Due Diligence
In the legal and financial due diligence that accompanies the next financing round or an M&A, the company will be asked to submit materials confirming the terms and procedures of past stock options. The terms of issue of the stock acquisition rights, the minutes of shareholders' meetings and board of directors meetings, the allotment agreements, and consistency with the capitalization table are examined in detail.
What is strictly questioned at this review stage is less whether the plan design looks tidy than whether the company can explain the reasonable grounds for the management judgment behind each grant. Why were those terms chosen? Why was that number granted to that person? How were the rights of past departing employees handled? How were the tax-qualification requirements verified? Are unexercised options accurately reflected in the cap table? A company that can explain this history in an orderly way and one that cannot will differ in the burden of responding to due diligence and in the impression made on investors.
In particular, companies whose records for the unexercised options of departed employees form a consistent chain, covering the contractual forfeiture process, the notice of confirmation to the person concerned, and the reflection of the cancellation in the cap table, can move through the review smoothly.
Even after issuance, record the status of vesting and exercise in a register. Upon departure or M&A, keep records of the provisions that form the basis of the treatment and of the procedures followed.
When the organization expands rapidly after the Series A, the work of managing stock options becomes exponentially more complex. Even if a simple spreadsheet was enough at first, as the number of grantees increases, departures occur, and additional grants are repeated, practical deficiencies such as omitted entries and calculation inconsistencies become more likely.
Keeping a Decision Memo at the Time of Grant
In stock option practice, I propose an operating practice of keeping a brief "decision memo" for each grant, separate from formal documents such as resolutions and allotment agreements. This memo need not be a lengthy report; it is sufficient if, looking back later, one can see what considerations the management at the time based its judgment on.
The main items to record include the following.
- The grantee's name, title, and role within the company
- The category of the grant's purpose (new hire, retention, promotion, special achievement, outside collaboration)
- The specific contributions expected going forward
- The balance with basic compensation such as cash salary
- How fairness with existing members was considered
- The design rationale for the number of options, exercise price, vesting conditions, and departure treatment
- Matters confirmed regarding the tax-qualification requirements
- An organized list of matters that could become issues in explanations to investors or in the next round
If such decision memos are kept, the history of the company's decision-making can be traced accurately even if the people in charge of HR or legal change in the future. The company can also explain the background of the grants to investors and prospective buyers on the basis of the materials considered at the time.
Where Outside Attorneys and In-House Legal Work Together
In designing the plan, the terms presented at hiring are checked against the procedures under the Companies Act and the tax-qualification requirements. This is the work of reflecting the grant policy decided by management in the contracts and in operations.
When engaging outside attorneys, share not only the terms of issue but also the cap table, the hiring plan, and the internal decision memos. This allows the company to consult on revisions to the terms and the necessary procedures in light of its policies.
At LegalAgent, we have a support structure in which attorneys with expertise in generative AI and corporate law work together to review startups' capital policy, investment agreements, shareholders' agreements, and stock option design.
At our firm, after confirming the conditions for information management, we have AI assist with comparing cap tables, grant histories, and investment agreements, and with drafting. Attorneys carry out the legal analysis, and we assemble the materials management needs to decide who should receive rights and at what level.
Consultations on Stock Option Design and Capital Policy
If you would like to review your stock option plan and capital policy together around a Series A, please see the details of our support on the following pages.
Frequently asked questions
What is a stock option pool?
It is an issuance allowance for stock options reserved in advance for future officers and employees. The size of the pool is a matter for negotiation with investors and ties directly to the capital policy question of whose holdings will be diluted by that amount.
Up to what percentage of issued shares can stock options be issued?
There is no uniform legal cap, but in practice it is common for the pool to be managed within a certain ratio agreed with investors. Rather than the ratio figure itself, the design of who receives how much within the overall capital policy is likely what matters.
Why is the timing of issuance important?
Because the exercise price is based on the market value of the shares at the time of issuance, the earlier options are issued before the company's value rises, the greater the economic benefit to grantees. Terms can change significantly before and after a fundraising.
Services connected to this topic