Creating an Employee Stock Option Plan: Decisions to Make Before Setting It Up in Carta

Decide who the plan actually covers

One clarification first, because the phrase is overloaded in the US. This piece is about an option plan: a reserve of shares that employees, advisors and contractors receive the right to buy at a set price. It is not an ESOP in the US sense, which the IRS defines as a section 401(a) qualified retirement plan designed to invest primarily in employer stock. Different instrument, different rules.

An "employee stock option plan" rarely covers only employees. Most early-stage plans are written to allow grants to three groups, and each is treated differently:

One Delaware plan we support reads the eligibility clause this way: employees, plus independent contractors "who are natural persons" providing bona fide services that aren't connected to raising capital. That last condition matters. Equity paid to someone for introducing investors is a different problem, and the plan won't cover it.

A payments startup we recently onboarded is a good example of why labels matter. Its Carta cap table carried four advisors and two equity-only contributors. The two contributors were contractors, not employees, with consulting agreements expected to be part equity and part cash. None of those six people should be treated as employee-option holders, even though they'll sit in the same plan.

ISO or NSO: the recipient mostly decides it

For a US corporation, the choice between incentive stock options (ISOs) and non-qualified stock options (NSOs) is largely made for you by the recipient's status. ISOs are only available to employees. Advisors, directors and contractors get NSOs.

The Delaware plan above shows how this plays out in practice. Of its first 22 grants, most went out as ISOs to employees, while a handful of advisor and contractor grants were issued as NSOs at the same strike price. Same plan, same vesting, different tax treatment.

ISO status also comes with conditions the plan has to build in under Section 422 of the Internal Revenue Code:

• Exercise price of at least 100% of fair market value at grant, or 110% for anyone holding more than 10% of voting power
• A maximum term of 10 years, or 5 years for a 10% holder
• No more than $100,000 of ISOs, measured at grant-date value, first becoming exercisable for one person in a calendar year; the excess is treated as NSOs
• Shareholder approval of the plan within 12 months of board adoption, or ISOs granted in the meantime become NSOs
• Holding periods of 2 years from grant and 1 year from exercise for the employee to keep ISO treatment

The practical upside of an ISO is no ordinary income at exercise, though the spread can trigger alternative minimum tax. An NSO generates ordinary income on the spread at exercise, with withholding if the holder is an employee.

If your team includes Canadians, none of this carries over. Canada has no ISO equivalent. Employee options are taxed under section 7 of the Income Tax Act, with different rules for Canadian-controlled private corporations and an annual vesting limit for other employers. A US parent granting to Canadian staff needs both sets of rules in view before the grant, not after.

The Canadian rules in brief

For a Canadian employee, section 7 deems an employment benefit equal to the share's value at exercise minus what the employee paid for it, taxed in the year of exercise. Two reliefs change the picture. First, paragraph 110(1)(d) allows a deduction of one half of that benefit where the exercise price was at least fair market value at grant, the shares are prescribed shares (broadly, common shares without preferential rights), the employee deals at arm's length with the employer, and the security is not a non-qualified security. Second, if the employer is a Canadian-controlled private corporation, subsection 7(1.1) moves the benefit to the year the employee sells the shares rather than the year of exercise, and paragraph 110(1)(d.1) grants the half deduction on those CCPC shares if they are held at least two years, even where the price test is not met.

The annual vesting limit is the piece founders miss. Where the employer, or the group it belongs to, is not a CCPC and has gross revenue over $500 million, subsection 110(1.31) treats options vesting in a calendar year above $200,000 of grant-date value as non-qualified securities: full employment income, no half deduction. A startup granting under a US parent should settle which side of the CCPC line it sits on before it tells Canadian staff what their options are worth after tax.

Set the terms before you enter a single grant

Every grant needs five terms documented somewhere other than Carta: who receives it, how many options, the exercise price, the vesting schedule, and the cliff. The plan sets the outer limits; the board consent and award agreement set the actual numbers.

Here are the recorded terms from our two examples side by side. They're illustrations of what founders actually chose, not recommended defaults.

A few things stand out.

The exercise price needs a basis. A US company granting options below fair market value runs into Section 409A, which can bring immediate taxation and penalties for the holder. The Delaware company's strike moved from $0.11 to $0.45 between grant rounds because its valuation moved. A $1.00 strike chosen as a round number, with no valuation behind it, is a decision someone will be asked to defend later.

Advisor vesting is usually shorter. A 24-month schedule with a 6-month cliff is a common shape for advisors, whose involvement is expected to be front-loaded. Four years with a one-year cliff is the employee norm. Neither is required.

Termination terms are part of the deal. What happens to vested options when someone leaves is often the most disputed term in practice. The Delaware plan defaults to three months to exercise, which is also the window that preserves ISO status. Decide it up front and put it in the award agreement.

Write down what the grant is in exchange for. For a contractor taking part of their fee in equity, the consulting agreement should say so, including how the equity portion was sized. Otherwise the grant looks like compensation with no documented service behind it.

Connect the plan to the cap table first

An option is a right to buy a specific class of share. If the share classes on your cap table aren't settled, you can't say what the option is over.

The payments startup illustrates this. Its Carta cap table showed Class A and Class B shares, described in our notes as preferred and common, with the founder holding 10,000,000 Class A common shares. That description doesn't line up cleanly: is Class A the common or the preferred? Before any advisor grant is recorded, the company needs to confirm from its articles or charter which class the options convert into, and what rights that class carries.

Three questions to answer before recording grants:

1. What exactly is outstanding? Every issued share, by class and holder, reconciled to the corporate minute book, not just to Carta.
2. How big is the pool? The plan needs a fixed share reserve, approved by the board and shareholders. The Delaware plan started with 1,500,000 shares, and its ISO limit was set at twice that reserve.
3. What does each grant do to dilution? Fifty thousand options means something different against 10 million shares outstanding than against 1 million. Founders should see fully diluted ownership before and after the pool, not just the pool size.

If the plan reserve is too small for the grants already promised, the plan itself handles it badly. The Delaware plan's wording is that an award exceeding the reserve won't become exercisable until the reserve is increased, and can terminate if that doesn't happen within a year. That's an awkward conversation to have with an advisor.

What Carta does, and what it doesn't

Carta is a record-keeping system. It tracks your cap table, issues and tracks options and shares, runs vesting schedules, and sends grant documents for acceptance. It's very good at that, and many of the startups we work with use it.

What it doesn't do is make the underlying decisions valid. The Delaware plan says this directly: if the board's records and the award agreement disagree on exercise price, vesting or share count, the board's records control. Carta holds a copy of the terms, not the authority for them.

In practice, the order of operations looks like this:

1. Adopt the plan and fix the share reserve (board, then shareholders)
2. Approve each grant by board consent, with recipient, number, type, strike and vesting
3. Get a valuation that supports the strike price
4. Sign the award agreement, plus a consulting or advisor agreement where relevant
5. Record the grant in Carta to match the consent exactly

Carta can also help on the accounting side. Options granted to employees and service providers are an expense under ASC 718 for US GAAP reporters, measured at grant-date fair value, typically with a Black-Scholes model, and spread over the vesting period. Carta sells a reporting module that produces those calculations and journal entries. For the Delaware company, we run our own Black-Scholes schedule off the Carta export and book the expense monthly. Either way, someone has to own the numbers, reverse expense on forfeitures, and tie it back to the books.

Checklist before the first grant

The details below depend on your jurisdiction and structure, so have counsel and your tax adviser confirm each one:

• Plan document drafted for the right jurisdiction, with eligibility covering employees, advisors and contractors as intended
• Board adoption and shareholder approval, within 12 months if you want ISOs
• Share reserve sized against fully diluted ownership, with the option class confirmed in the charter or articles
• Each recipient classified as employee, advisor or contractor, and ISO or NSO assigned accordingly
• Valuation in place to support the exercise price (a 409A valuation for US grants)
• Vesting, cliff, term and post-termination exercise window set for each grant
• Canadian recipients reviewed under section 7 of the Income Tax Act and the annual vesting limit in subsection 110(1.31), and any securities filings checked
• Award agreements and consulting or advisor agreements signed
• Grants entered in Carta to match the board consent exactly
• Stock-based compensation expense process agreed: who calculates it, and how often it's booked

Quick answers

What is the difference between an ISO and an NSO? An ISO is only available to employees of a US corporation and, if the Section 422 conditions are met, produces no ordinary income at exercise, though the spread can trigger alternative minimum tax. An NSO can go to anyone the plan covers and produces ordinary income on the spread at exercise. Same plan, same strike, different tax treatment.

Can I give options to a contractor? Usually yes, if the plan allows it and the contractor is an individual providing real services. They'll be NSOs, not ISOs.

Do I need a valuation before granting? For a US company, yes in practice. Granting below fair market value can create 409A problems for the holder.

How big should a startup option pool be? There is no statutory number. The reserve is whatever the board and shareholders approve, and it should cover the grants already promised plus the hires planned before the next round, sized against fully diluted ownership. The Delaware plan in this piece started at 1,500,000 shares, and its own wording makes any grant above the reserve unexercisable until the reserve is increased.

Can Carta set my vesting schedule? Carta applies the schedule you enter. The board decides what it is.

Do Canadian employees get ISO treatment? No. Canadian tax rules apply to them, whatever the plan calls the option.

Where this leaves you

If you're about to promise equity to your first hires, advisors or contractors, settle the terms on paper first and use Carta to record them. Getting the order right costs a few weeks. Fixing it afterwards, across a cap table, a set of award letters and your financial statements, costs a lot more.

Ready to build your finance backbone? Book a free consultation with a CPA who works with founders every day. I am Mo, a partner at Convoy. Our model is to act as your CFO and your finance operations team: think of it as a full finance department, responsive and sometimes on site, with experience across finance, tax and operations for startups up to Series B.