THINGS TO THINK ABOUT WHEN MAKING DECISIONS ON A STOCK OPTION PLAN FOR YOUR COMPANY
A stock option is a benefit awarded by a company in the form of an option to another party, typically an employee or consultant, to buy stock in the company at a stated fixed price within the predetermined terms and schedule of the plan or upon meeting certain corporate goals.
Simplified example: An employee is given 100 options to purchase 100 shares at $10 per share for a period of one year starting in three years. If after three years the stock price has risen, say to $15, the employee can exercise the options and purchase the shares at the exercise price and realize a gain of $500 upon sale of stock, or can choose to hold the stock for larger potential future gains.
Basic terminology to know:
Exercise: is the payment of the Exercise price of an option and the subsequent issue of the share(s) subject to the option
Exercise price (strike price): the specified contract price at which the holder can buy the share(s)
Spread: difference between exercise price and market value at the time of exercise
Option term: the period or duration of time the employee can hold the option before its expiration or exercise of the option
Vesting period: the required time that a holder must wait before a holder can exercise an option
Attracts talented employees for the long term: Stock options can be gifted or granted with employment packages to attract talented individuals and incentivize them to perform well while also ensuring that they share a common interest with shareholders in boosting the company’s stock value and staying with the company at least until such time that they are able to exercise the option. Offering stock options can be especially appealing to startups who do not have the financial means to offer large salaries at the beginning of employment as it allows them to be competitive with established companies. Stock options are not just for employees – they can be used to compensate service providers, contractors and attract talented board members.
Choosing shares and options: There is some flexibility when it comes to deciding how many shares and options you want to offer employees. Typically, 5% to 20 % of outstanding shares are set aside for employee stock options, but it is ultimately up to the company’s board and / or equity holders to determine the percentage. There are two kinds of stock options: incentive stock options (ISOs – reserved for employees) and nonqualified stock options (NSOs – used for all others). The difference between the two is the tax benefit of ISOs in which taxation can be deferred and may potentially qualify for capital gains rates rather than normal income tax rates. A stock option plan can contain other tools as well that the board may use instead of stock options, such as Stock Appreciation Rights and Restricted Stock and outright stock grants. A good stock option plan will provide the board with tools to fit any situation.
Determine particulars: A party or parties should be assigned the responsibility of overseeing the deployment of the stock option plan, and the vesting schedule should also be determined as well as the amount of the exercise price and transferability specifics, typically by the Board.
Dilution: The main disadvantage of offering stock option plans to employees is the possibility of dilution of existing shareholders. This can happen when employees exercise their options causing the number of existing shares to increase which thus, decreases the percentage ownership provided by each share.
Address end of employment: A good stock option plan will clearly address what happens to the options in the event the employee is terminated, voluntarily leaves, passes away, and like situations. You don’t want options continuing to vest after an employee leaves or is terminated.
Compliance: The issuance of options and underlying shares requires compliance with federal and state corporate and securities laws; therefore experienced corporate legal counsel should be consulted throughout the entire process.
Transferability: Most stock option plans do not allow for the transfer of options during the life of the employee. The transferability of the stock resulting from the exercise of the stock option will depend upon factors including whether the company is public or private. Experienced legal counsel will be helpful with these issues.