An employee stock option is a contract between a company and its employee that gives the employee the right to purchase a specified number of shares of stock in the company at specified strike price by a specific date. The employee is under no obligation to purchase all or part of the number of shares granted in the option. Typically, but not always, the number of shares granted vest over time.
Companies establish employee stock option programs as part of an overall employee compensation plan for several key reasons. Option programs can boost employee morale and help attract talented, skilled workers who are motivated to help the company improve and succeed. Employees holding options to purchase shares feel more like owners or partners in the business and are invested in the company’s success. In addition to being a benefit for employees, stock option plans are cost-effective for companies with the only significant costs to the company being the lost opportunities to sell some stock at market value in the future (since employees usually buy at a discounted rate) and the expense of administering the plan.
While stock options are an excellent choice for companies wishing to offer employees a cost-effective benefit tied to the company’s future success, entrepreneurial businesses must be cautious to avoid the following pitfalls when using stock options as a form of compensation:
1. Setting the option strike price too low…or too high.
Under Section 409A of the Internal Revenue Code (IRC), a company must ensure that any stock option granted as compensation has an exercise price equal to (or greater than) the fair market value of the underlying stock as of the grant date. If the option strike price is set too low, the options will be considered deferred compensation, the recipient will face significant adverse tax consequences, and the company will have tax-withholding responsibilities.
While there is no regulatory penalty for setting an option strike price too high, the option is not as valuable to the holder as one with an appropriate strike price. A company can establish a defensible fair market value of the underlying stock by obtaining an independent appraisal from well-qualified experts.
2. Forgetting to issue options “on time.”
Stock options offer employees the opportunity to benefit from the increase in the company’s value over time. As a company meets operational milestones, the value of the company will increase, and the value of the underlying shares of stock of the option will also increase. It’s easy for management to get caught up in the daily responsibilities of running and growing a business thereby forgetting to take the necessary legal steps to grant options in a timely fashion. However, the issuance of stock options to key employees should be done as soon as possible, when the value of the company is as low as possible, if they are to provide the most value to the employees.
3. Establishing a large option pool that dilutes shareholders
When establishing an employee option pool, companies planning to seek equity investors should consider how investors calculate price per share. Venture capitalists calculate the price per share of a company by dividing the total pre-money value of the company by the “fully diluted” number of shares outstanding. For the purposes of this calculation, fully diluted shares include not only issued and outstanding shares but also the number of shares currently reserved for an employee option pool as well as any increase in the size (or the establishment) of the pool required by the investors for future issuances. Investors typically require an option pool of approximately 15-20% of the post-money, fully diluted capitalization of the company. Obviously, existing shareholders (including the founders) are substantially diluted by this approach. The only way to avoid unnecessary dilution is to keep the option pool as small as is feasible while still attracting and keeping the talent needed to grow a business.
4. Understanding the differences between ISOs and NSOs
Incentive Stock Options (ISOs) are regulated by IRC Section 422, which lays out the requirements for an equity instrument to qualify as an ISO. ISOs are only available for employees and must be granted pursuant to a shareholder plan. The exercise price of an ISO may not be lower than 100% of the fair market value of the underlying stock at the time of the grant.
Non-statutory Stock Options (NSOs) have fewer regulations and restrictions than ISOs. NSO’s can be offered to advisors, service providers, and others affiliated with by not employed by a company. However, ISOs uniquely offer the possibility of being taxed under long-term capital gains, while NSOs are taxed under both ordinary income and capital gains. That said, if employees don’t follow all the holding rules, then the favorable tax treatment of ISOs no longer stands.
5. Restricted Stock vs. Options
Restricted stock can be a good alternative to options as a means of employee compensation in early stage companies for several reasons. Unlike options, restricted stock is not subject to Section 409A regulations. Restricted stock may better accomplish the goal of motivating employees to behave in the best interest of the business since the employees are actually receiving shares of common stock of the company. Under IRC Section 83(b), employees holding restricted stock will be able to obtain capital gains treatment, and the holding period begins upon the date of grant, provided the employee files an 83(b) election.
The disadvantage of restricted stock is that upon the filing of an 83(b) election (or upon vesting, if no such election is filed), the employee is considered to have income equal to the then fair market value of the stock. Thus, if the stock has a high value, the employee will have significant income and must possess the necessary cash to pay the applicable taxes. Thus, restricted stock issuances are not appealing unless the value of the stock is sufficiently low that tax impact is minimal as is generally the case immediately following the company’s incorporation.
6. Options for LLCs?
Limited Liability Companies (LLCs) have grown in popularity as a vehicle through which entrepreneurial companies operate their business. An LLC shares many corporate characteristics, but most are taxed as partnerships. Thus, the LLC structure has clear benefits, but also faces significant challenges in the area of equity compensation. Within an LLC, ownership is expressed by membership interests rather than stock. As a result, LLCs cannot create employee stock ownership plans (ESOPs), issue stock options, provide restricted stock, or otherwise give employees actual shares or rights to shares.
However, like corporations many LLCs want to reward employees with an equity stake in the company. The most commonly recommended approach to sharing equity in an LLC is to share “profits interests.” A profits interest is comparable to a stock appreciation right. It is not literally a profit share, but rather a share of the increase in the value of the LLC over a stated period of time. Vesting requirements can be attached to this interest. Options to purchase profits interests can also be granted. Entrepreneurs should be aware that while LLCs are flexible entities that provide tax efficiencies not available in corporations, they tend to be more expensive to form and administer than corporations, especially given the unique requirements surrounding employee compensation.
The information provided here is for educational purposes only and is not intended as tax advice. Oxford Valuation Partners does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Oxford Valuation Partners assumes no responsibility for the tax consequences to any investor of any transaction.