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For a small startup, I'd like to give options to members of an advisory board and one other person. However, one of my lawyer friends says to wait until after the first round of financing to give them.

Is he right? If so, how could startups ever get advisory boards and other people who want options?

Thanks.

EDITED TO ADD: Thanks for answers 1 and 2 below. But why is it a problem to issue options before a financing round?

If all of the corporate formalities (such as board and stockholder authorizations) are followed, an option plan is authorized, option agreements are signed, etc., the paperwork is one issue that should be fine.

If a cap table is thoroughly done and a small number of options are issued, the cap structure will be clear.

With those two items addressed, why would an investor care if say 1% of the company's fully-diluted share pool consists of options before the first investment round?

Thanks for the advice- I'm just not understanding why it's a problem if a company is meticulous about things.

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2 Answers

up vote 7 down vote

Your lawyer friend is wrong. You want to give options as early as possible, so that you can get as low a strike price as possible.

Under current 409A valuation rules in the United States, the options strike price must be based at the fair value of the company for the time they are issued.

If you issue options when the company is brand new, the fair value is pretty darn close to zero.

The first time you raise capital, the fair value price will go up. This will make the strike price of the options higher, and therefore the options will be worth less to the people you give them to.

You do need good paperwork from a lawyer who is familiar with startups. This may cost some non-zero amount of money (although some lawyers in the high-tech startup community are happy to do simple basic paperwork for free for startups in expectation of getting future business.) You may decide that in your situation you'd rather wait until you're absolutely sure that the business is going ahead before you invest in all the paperwork.

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up vote 1 down vote

I think you're getting good advice about having your capital structure solidly in place before you start giving out specific equity grants.

Make clear in your LLC documentation that you have reserved X # of shares for options for advisors, employees and others.

Once you get the LLC established and raise your first round, formally issue the options then.

You can certainly say to a prospective advisor " our expectation is to have a capital structure that looks like this.... and our expectation is that we'll have X # of shares for options and we'd expect to reserve Y # of these for our advisors. These will vest over a 2 year period and will require advisors to meet a specific set of objectives such as participating in advisor meetings." (more on this in other questions on this site)

It is definitely worth working with an attorney who has done this multiple times before. You'll spend a few bucks to do this but it's worth doing right.

Tip - make SURE you file an 83 B election with the IRS within 30 days of establishing the LLC. There are other questions on this site plus many good web links on this topic. Net is you have a one time chance to establish your cost basis. Do NOT screw up the timing on this. The IRS is remarkably clear on the rules here.

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Thanks. What if options were given out before the first external capital raise? What if only a small number of options were authorized and issued before the first financing round? Is the issue just that the capitalization isn't fully settled, or will it make investors not want to invest? Thanks again. – user6492 Apr 16 '11 at 19:50

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