Can Startups Issue Stock Options to Customers?

A growing trend for startups has been to offer stock options to customers as part of loyalty programs or incentives for purchases. While it's tempting to issue these options, there are several important considerations that must be taken into account to avoid legal and compliance issues.

Legal Framework

The issuance of stock options is subject to securities laws and regulations. Startups must ensure compliance with these laws, which can vary by jurisdiction. These regulations include registration requirements or qualifying for an exemption. This complexity necessitates careful planning and consultation with legal and financial advisors.

Type of Options

Stock options can be structured in various ways. For customers, they might be offered as part of a loyalty program or as an incentive for purchases. However, the terms must be clearly defined. This ensures that both the startup and the customer understand the conditions under which these options can be exercised.

Valuation

The startup must determine the fair market value of its stock to establish the exercise price of the options. This valuation is crucial for compliance with tax regulations and for ensuring that the options are attractive to customers. Accurate valuation must be based on market trends and financial data to avoid disputes and penalties.

Tax Implications

Both the startup and the customers may face tax implications when stock options are granted and exercised. It's important to understand these implications to avoid unexpected liabilities. This includes understanding the corporate and personal tax consequences of holding and exercising stock options.

Customer Engagement and Communication

Offering stock options to customers can enhance loyalty and engagement. However, clear communication about the benefits and risks associated with holding equity in the company is essential. This includes providing comprehensive information about the startup’s business model, financial health, and future plans.

Advisory

Startups should consult with legal and financial advisors to structure the option plan appropriately and to navigate the complexities involved. Proper advice can help ensure compliance with securities laws and avoid potential legal issues.

Why Issuing Private Company Stock Options to Retail Customers is a Bad Idea

Issuing private company stock options broadly to retail customers is a bad idea and runs afoul of multiple regimes of securities law. Here's why:

Securities Registration Requirements

First and foremost, the company must be a public company if it is engaged in the public solicitation of securities sales. Giving stock options to people in exchange for their being customers is just that – offering a security to the public in exchange for compensation. The United States Securities and Exchange Commission (SEC) requires that securities be registered with the SEC, unless an exemption can be found. This is a clear violation of securities law if the company is not registered. For example, in the case of Travelzoo, it learned this the hard way, giving away about 4.1 million shares to the first 700,000 people who signed up on its website. This is a warning to other startups.

Crowded Shareholder List

Travelzoo's experience highlights the potential nightmare of having a large number of shareholders. Anything over about 20 shareholders places a company in a different regime of regulation and shareholder relations and disclosure. Anything over 100 and a company is looking at a huge bill if it wants to use software like Carta to keep track. Beyond 500, good luck hiring a full-time employee to keep everything current and accurate. Anything over 2,000 stockholders, i.e., 2,000 customers exercise their options, and the company has to go public whether it wants to or not. So imagine having 4 million shareholders like Travelzoo. They lost track. If you lose track, you can't audit your financials, it's hard to raise money, you can't fill out forms, and you have to put an asterisk by everything.

Rule 701 Exclude Retail Customers

Lastly, Rule 701, the securities safe harbor used for stock option plans, only allows grants to active service providers such as employees, contractors, advisors, and board members. You can't issue options to customers under a plan if you want the plan to qualify for this safe harbor. This rule requires the recipient to be an individual or a personal corporation or LLC that is an alter ego of the individual service provider. Corporate service providers don't qualify. In other words, startups can and do offer stock or warrants on an ad-hoc basis to key customers and strategic partners, but almost never options under their stock plan. This is based on the premise that after a customer and the startup come to know each other well, there is a substantial pre-existing relationship so the offer to give them stock is not a solicitation made generally to the public.

Given the complexity and potential risks involved, startups should be cautious about issuing stock options to customers. Consulting with legal and financial experts can help navigate these challenges and ensure compliance with securities laws.