Understanding incentive stock options in a consulting contract for a startup
<p>I have a verbal agreement with a pre-seed startup to do some work for them on a part-time, consulting basis. We had agreed to some cash and a specific equity percentage and vesting schedule (x% over y years).</p>

<p>I got the contract today, and the only place stock is mentioned is in the following paragraph, which seems to be talking about a stock incentive plan for me to purchase stock, not for me to just be granted it as part of my compensation:</p>

<blockquote>
  <p>Subject to the approval of the Board of Directors of the Company, the
  Company may grant to you an incentive stock option (the "Option")
  under the Company's 2018 Stock Incentive Plan (the "Plan") for the
  purchase of an aggregate of 72,000 shares of common stock of the
  Company at a price per share equal to the fair market value at the
  time of Board approval. The Option shall be subject to all terms,
  vesting schedules and other provisions set forth in the Plan and in a
  separate option agreement.</p>
</blockquote>

<p>How do I interpret the above statement? It doesn't seem to say anything about my agreed on equity stake in the company as part of my compensation. Should it? What language would it use?</p>

<blockquote>
  <p>How do I interpret the above statement? It doesn't seem to say anything about my agreed on equity stake in the company as part of my compensation.</p>
</blockquote>

<p>You are right. The written clause is inconsistent with the verbal agreement.</p>

<p>If you sign the written contract, it would supersede the verbal agreement because a contract typically replaces and supersedes any prior [overlapping] agreements between the parties. Also, it is easier to prove the formation of a written contract than the terms of a verbal and unrecorded agreement.</p>

<p>The written clause provides that your compensation (or part thereof) will be in the form of <a href="https://en.wikipedia.org/wiki/Call_option" rel="nofollow noreferrer">call options</a>, which has nothing to do with the equity percentage per the verbal agreement. You will need a clause that clearly reflects the verbal agreement: <em>x%</em> to be delivered in <em>y</em> years.</p>

<p>If you decide to go for the stock options plan, you need to be aware of some vulnerabilities that the written clause entails.</p>

<p>The clause is unclear as to <em>when</em> the Board would approve the Plan. The problem with that uncertainty is that the <a href="https://en.wikipedia.org/wiki/Strike_price" rel="nofollow noreferrer">strike price</a> is made dependent on the date of approval ("<em>fair market value at the time of Board approval</em>"). The Board could deliberately render your compensation negligible by approving the plan with a timing that minimizes the difference between <em>fair_market_value_at_expiry_date</em> and <em>strike_price</em> (that is, the <a href="https://en.wikipedia.org/wiki/Strike_price#Mathematical_formula" rel="nofollow noreferrer"><strong>max(S-K,0)</strong> expression</a>).</p>

<p>That vulnerability can be preempted by determining the strike price beforehand and independently of the fair market value on an undefined date of approval.</p>

<p>The clause or the "separate option agreement" should include language to the effect of addressing <a href="https://en.wikipedia.org/wiki/Stock_split" rel="nofollow noreferrer">stock splits</a>, since the clause is in terms of number of stocks rather than percentage of equity. Stock splits would dilute the value of each one of the 72,000 shares the plan would entitle you to purchase. Absent a contractual protection against that dilution of shares, the startup could split stocks so as to deliver the plan stocks without actually giving up much of its equity.</p>

<p>I haven't really searched for <a href="http://www.leagle.com/leaglesearch?all=options&amp;exact=stock%20split" rel="nofollow noreferrer">case law</a> regarding compensation in the context of stock splits. But, although you might be entitled to relief in case the company indulges in manipulation/fraud of the stock price, it is in your best interest to avoid litigation risks by ensuring that the language of the contract reflects your understanding and your expectations.</p>

<p>This is a complicated area of business and law. As the letter says only the board can authorize the stock deal and any executive who promises otherwise is making a big mistake. If they were to grant you options at lower than the market value there can be imputed income now that you can be taxed on. Sometimes that is a good thing and there is form I once filed with the IRS that says “tax me now even though this option may prove worthless in the future” to avoid larger taxes later. </p>

<p>Of course the number of shares is meaningless without knowing the total number of shares. Stock splits will not normally be an issue but dilution can be a big issue. The letter cites an existing stock option plan. You need to have a copy of that. Hopefully it addresses the stock split issue and otherwise clarifies what you are potentially being offered.</p>

<p>If you were a venture capitalist putting in money for stock you would have an agreement that protected you the in the stock split case, dilution, and many other actions like the company officers assigning the IP to a new company and leaving you with shares in a company with no assets. As a contractor you will not be able to get the protections a VC would get and, unfortunately, some trust will be needed to be extended on your part for this to work out in practice.</p>

<p>Iñaki Viggers's answer is excellent.  I can only supplement it with a few additional points from my own experience:</p>

<p>Overall, the language that you quote could be described as fairly standard for an agreement for independent contractor services.  That is, the negotiated percentage, x%, is indeed typically converted to a number of shares at the time the contract is signed.  Even when a percentage is listed, the number of shares is usually taken to supersede it, largely because dilutional events may happen at any time.  In particular, if the startup has an option pool, then you are typically protected from dilution by other independent contractors until this pool runs out.  But you would generally not be protected from dilution in seed rounds (unless this is somehow negotiated beforehand, and this would be unusual).</p>

<p>All that is to say, if it was me, I would be less concerned with the quoted language than the terms of the ISO itself, as specified by the Plan.  Check out what these terms are; if for example you were expecting restricted stock instead of options, you could potentially ask the company to increase your cash compensation by the amount of the strike price times 72,000 to cover the cost of the "buy in."  Additionally, you may want to confirm that the startup is obtaining 409A valuations from a qualified, independent appraiser or valuation services firm, since you share in the legal risk if they aren't.</p>

<blockquote>
  <p>How do I interpret the above statement?</p>
</blockquote>

<p>The only force this section has is that <strong>if</strong> the company gives you stock options, <strong>then</strong> there will be restrictions on them. This is not in any way a promise of stock options, let alone stock. You should regard this as a complete lack of any equity being promised. You should point out that this is not what you agreed to, and tell them that they will need to honor their prior agreement.</p>

contract-law equity