California Stock Option Plans Get Friendlier

March 6th, 2007

The California Department of Corporations seems likely to adopt a new set of rules affecting compensatory benefit plans by the end of March. The rules cover a variety of plan types, but stock option plans are the most commonly used type of plan.

Vesting Terms Reflect Real Life
The new rules generally conform California law to IRS rules. California has a few requirements that aren’t covered by the IRS, so the changes will help to avoid a few different “gotchas”. Some of them are basically stenographic, such as the (soon to be former) requirement that options vest at least 20% per year. I have not yet worked with a company that used a 5 year or longer vesting period, so the issue was moot for all practical purposes, but the language still needed to be in the plan. It always makes me happy when I cut language out of a document, so this is a nice step.

2/3 Shareholder Voting to be (Mostly) Eliminated
The other notable “gotcha” is the funny rule that companies can not have options outstanding to purchase shares in excess of 30% of the company’s capitalization without 2/3 shareholder approval. The new rules would eliminate the 2/3 voting requirement (majority vote for option plans is still required for favorable tax treatment) if the plan otherwise complies with IRS rules.

It is the rare company that *needs* that many options outstanding, but I have once or twice encountered a situation in which it made sense, esp. the “late co-founder” situation where a person comes in after the stock price has risen and assumes such a critical role that s/he should be treated as a de facto co-founder for equity purposes.

In those cases, it may be too expensive for him/her to buy founder’s stock and an option is the simplest way to get a substantial equity share to the person. Once or twice I have worked with companies where it has made sense to authorize options in this situation, pushing it up to the 30% of outstanding capital limit. Shareholder voting would not be required to issue stock outright to the person, so it is nice to see that the voting requirement has been eliminated if the equity comes as an option as well.

California Steps into Line
All in all, the new rules aren’t particularly momentous, but that is really the point. California is such outlier on so many issues, with its own special rules, that it is nice to see it simply come into line with “standards”.

  • Thank you for this blog posting. Useful to know about these upcoming expected changes in stock option laws. Is there any discussion of changes in the California tax code related to infamous IRC Section 409A for options that are considered discounted because they are either intentionally or unintentionally backdated?

    What are you recommending that very early stage and later stage start ups do to justify/show the reasonable fair market value of their exercise price to satisfy both IRC and California tax laws?

    Bruce Brumberg, Editor

  • Good question. To my knowledge there is no discussion of 409A-like legislation at the California level. People are still trying to figure out exactly what 409A means and mostly just wishing it would go away, it seems to me.

    Early stage companies that have conducted an outside, professional-investor financing can often use that as a pretty good baseline for determining stock price.

    I have occasionally referred clients for official 409A valuation analyses, but most companies seem content to do the valuation in-house. The biggest trick is figuring out the proper discount of common to preferred stock- and I have found no strong consensus there.