Common Mistakes to Avoid When Issuing Company Shares
Stock options are now a crucial component of market remuneration. These days, it’s common practice to provide new hires with stock options as an incentive to join the company. Because of the complicated procedure, there is a severe risk of making significant errors when granting stock options. First-time issuers of stock options are particularly vulnerable to blunders in this area.
Mistakes committed in issuing shares in a company may have far-reaching and lasting effects on the company’s finances. While stock options may help firms recruit and retain top talent, they can carry some risk if not issued correctly.
How Do Shares Work?
Equity share or stock is a unit of ownership in a corporation. They represent a shareholder’s financial stake in a business. A “share” refers to a fractional portion of a company’s share capital. As a means of raising funds, issuing shares in a company represents a sale of a corporate stake to shareholders.
The market sets the price of a company’s stock. Several variables, including the company’s financial health, market tendencies, and the state of the economy, might affect this indicator. Therefore, a person’s prospective profits or losses in financial terms due to the value of their shares might change dramatically and fast.
Issuing shares in company
When trying to raise funds, businesses may choose to do so by issuing shares in the company in a few different ways.
Here are some of them:
- Initial public offering- An IPO is the first time a company has made its shares available to the general public.
- Secondary Distribution- After an initial public offering (IPO), a secondary offering occurs when the firm offers more shares.
- Private placement- When a company distributes stock to a select group of investors, the transaction is known as a private placement.
- Equity Offering- When a company gives its existing shareholders the option to buy more shares at a reduced price, it is called an equity offering.
Example For Issuing Shares :
Let’s take case of Microsoft,
- Microsoft’s shares have been a good investment for investors over the long term. The company has grown steadily over the past few decades, and its stock price has reflected this growth. In 2011, Microsoft’s stock price was around $20 per share. Today, it is around $346 per share.
- As of August 4, 2023, Microsoft has 7.75 billion authorized shares, of which 7.55 billion are outstanding. Outstanding shares are the number of shares that investors currently hold. This means that Microsoft has issued 7.55 billion shares to investors.
- The total unissued shares of Microsoft are 200 million. This is calculated by subtracting the number of issued shares from the number of authorized shares: Authorized shares — Issued shares = Unissued shares
7.75 billion shares — 7.55 billion shares = 200 million shares
- Microsoft may choose to issue these unissued shares in the future to raise capital for its business or to use them for other purposes, such as employee stock options.
*A specimen of Microsoft stock certificate.
Steps Involved in Issuing Shares in Company
Let’s go through the process of issuing shares in company, which includes the following steps:
- Board consent- This step is crucial since it will save time and money when signing and organizing the company’s capitalization documents.
- Receive payment- The form of payment may include cash, goods, or services.
- Get the Necessary Documentation- Use this information during due diligence for a funding round or a sale of your firm.
For preferred shares, you’ll need shareholder approval, a stock purchase contract, and a set of ancillary agreements.
- Filing Securities- In a securities filing, a corporation explains to potential investors the process of investing and any potential dangers they may face.
- Certificate Issuance- While publicly traded corporations are exempt from this requirement, privately held ones are not.
Common Mistakes to Avoid in Issuing Shares
- Assuming that every stock option is identical
One of the most common mistakes to avoid in issuing shares is assuming that all stock options are equal. You may offer different stock options depending on your organization and workers’ goals. Standard options include ISOs and NSOs or non-qualified stock options. Two key distinctions are
1) Their intended beneficiaries and
2) Their tax treatment.
NSOs are for employees, advisers, directors, consultants, and contractors, whereas ISOs are for employees only. When an ISO holder receives a grant or exercises an option, they generally do not have to pay taxes on the transaction (although some may be subject to the alternative minimum tax).
Nonqualified stock option holders are subject to taxation during exercise and sale. Due to the potential tax benefits associated with ISOs, many companies want to provide them to their workers.
- Lacking “ISO” compliance
The US tax legislation provides preferential treatment for incentive stock options (ISOs), a specific kind of option. Subject to certain conditions, many option grants granted to US taxpayer workers may qualify for ISO treatment.
Companies frequently need to comply with the unique constraints that apply when the ISO beneficiary owns over 10 percent of the overall voting power of all classes of stock when issuing shares in the company.
For options granted to these 10% investors to qualify as incentive stock options:
- The exercising price must reach a minimum of 110% of the Fair Market Value upon grant, although most options have the same price.
- Instead of the standard 10-year term seen in most equity incentive schemes, the option term must expire within five years of the award date.
- The ISO rules also restrict the number of ISOs depending on the worth of available options (calculated at the time of award) in a particular calendar year. Businesses may exceed this limit by providing large or early exercisable option awards.
- Granting stock options beyond the pool
Companies often need to consider the pool of designated shares to offer stock options. A company’s board of directors must set aside a certain number before issuing shares in the company.
The Board of Directors sets the number of shares in the pool to limit stock dilution. It is possible to deter investors from purchasing shares by providing too numerous choices to workers without considering the restricted pool of shares.
A company’s standard allocation for stock options is 20% of the total shares. Limit the number of shares available for stock options to avoid diluting too much.
- Incorrect timing
It is crucial to provide choices at the appropriate moment after making the decision.
Depending on when you issue options (e.g., after receiving an investor term sheet), the exercise price of the options you grant to workers may be greater than what you had initially guaranteed. It might make them feel less enthusiastic about taking advantage of their choices or, even worse, hesitant to remain around.
For this reason, issuing shares in a company before having a term sheet in hand is not uncommon to offer stock options. Employees may benefit from a reduced workout price because of this policy.
- Not getting or Updating a 409A valuation
If your firm is private, you must first get a 409A appraisal to establish the FMV of your common stock before issuing shares in the company. You may determine each share’s striking or appropriate buying price using this FMV.
You and your firm might face severe tax consequences from the Internal Revenue Service if you issue options without a legitimate 409A value on file. Employees may be subject to steep interest penalties if the strike price of the options you issue is below the fair market value defined by the law.
A single valuation is sometimes insufficient. An updated 409A valuation is necessary, or more often in the case of a significant event or transaction (such as a new funding round), to maintain eligibility for the IRS’s 409A safe harbor.
Keeping up with your 409A values is thus essential. Make sure you schedule a fresh valuation at least once a year, and if you’re in the midst of a large deal, hold off on issuing any new options.
- Ignoring the stock option vesting schedule
The options provided to each employee while issuing shares in the company will vest according to individual timetables. The problem arises when an employee wishes to quit the firm and exercises their vested options before the organization adequately tracks the vesting timetable for each employee.
It is only possible to determine the proportion of an employee’s vested options at a given time if you are keeping track of the vesting timelines for each option. In addition, with a transparent vesting timeline, workers can know how far along they are in the process.
Automatic vesting tracking systems allow you to keep tabs on everyone’s vesting timeline and regularly notify workers of their progress through email.
- Not creating grant documents
Employers that want to provide newly hired workers by issuing shares in company should prepare and hand over appropriate grant documents. Not providing workers with adequately drafted and delivered stock option award documents may lead to administrative and legal complications down the line.
Stock option grant documentation includes vesting schedules, expiry dates, and termination periods. Providing the grant documents to the workers when giving options is a requirement for enforcing the conditions of the options.Therefore, writing and providing workers with the right stock options grant documents is crucial to prevent legal and administrative complications.
Streamline Equity Management with Confidence
If you make a mistake while giving options, you might lose key personnel, time, and money. Ensure you have everything in order before issuing shares in the company to prevent unintentionally causing headaches for your cap table or under-incentivizing your employees.
In addition to speaking with your attorneys, consider making an equity management solution purchase for a confidence move. It’s simple to secure board approvals, seek 409A valuations, issue electronic securities, and set up your cap table as a founder with software in place. It’s also easy for your staff to use. They will have a centralized location where they may see vesting schedules, exercise options, and receive electronic securities.
