This blog is the first post in a four-part series. Part I will provide a high-level summary of stock option basics.
In recent years, and at least in part due to the extremely tight labor market, private companies have increasingly been faced with the question of if (and how) they should make their equity incentive programs more attractive. Equity compensation, and specifically, the grant of stock options, has long been a critical component of a start-up company’s compensation package, giving employees the ability to participate in the company’s success while preserving the company’s cash for R&D and other business needs. But today offering to grant an employee, and perhaps particularly an executive candidate, an option is likely to be met with requests for preferential terms beyond those historically seen in plain vanilla option programs. In an attempt to make their stock options more desirable, companies are invariably led to consider one or more of the following “enhancements”:
- Granting options with early exercise features;
- Granting options with extended post-termination exercise periods; and
- Implementing employee loan programs.
For sure, it may well be appropriate for a particular start-up (based on its industry, geographic location or business goals) to pull one, or several, of these levers to ensure it attracts the best and the brightest. But it is also critical that any such decisions be made with eyes wide open. In this four-part series, we discuss each of these commonly-considered option program enhancements in turn, highlighting the pros and cons of each, identifying traps for the unwary, and focusing on relevant practical considerations.
In this first part, however, we focus on stock option basics, including what stock options are, how they serve as a valuable tool to recruit, retain and incentivize employees (and other service providers) and what their tax consequences are. Much of the information included in this Part 1 can be found elsewhere on WH Launch – we pull it all together for you here as a grounding in these concepts will be useful as we explore the topics described above in later posts.
Stock Option Basics
Stock Options Defined
A stock option, whether it is early exercisable or not (more on that in our next installment), gives its holder the right to buy shares of the company’s stock at a fixed price, known as the exercise or strike price, that is generally equal to the fair market value of the stock on the date of grant of the option. Over time—the hope is—the value of the company’s stock will grow (in part by dint of the option holder’s own eﬀorts) so that when the option holder exercises the option (that is, elects to buy the shares subject to the option), the option holder can buy the appreciated company stock at a discount. The option holder—now stockholder—can then sell the stock (subject to any restrictions on transfer the company may impose) and keep the proﬁts or continue to hold the stock and participate in any future growth as an investor in the company.
To ensure that the option holder actually stays at the company long enough to participate in company value creation—and, incidentally, this is how the option serves as a tool for retention—the right to exercise a stock option is usually earned (or “vests”) either over time or upon the achievement of pre-established performance goals. Most commonly, an option holder earns the right to exercise the option with respect to 25% of the shares underlying the option after one complete year of service (often called “cliff vesting”) and in equal monthly or quarterly installments for three years after that. Only once the option is vested can the option holder choose if and when (and the extent to which) to exercise the option. If the option holder leaves the company before the award is fully vested, the unvested portion of the award is forfeited. Upon exercise of the vested option, the option holder is issued fully vested shares of stock and becomes a stockholder in the company.
Other Standard Option Terms
In addition to options generally having exercise prices that are equal to fair market value on the date of grant and being subject to a vesting schedule, options also usually have a term of 10 years (though certain options granted to 10% stockholders may have a maximum term of five years). This term is shortened if the option holder ceases to be employed by (or otherwise provide services to) the company. Typically, the post-termination exercise period ends three months after a cessation of service (12 months, if the option holder ceases to provide services by reason of his, her or their death or disability) but the award is forfeited entirely if the option holder’s service is terminated for “cause”. If the option is not exercised (to the extent it is vested) by the end of the 10-year term (or the end of the applicable post-termination exercise period, if earlier), it will be forfeited.
Types of Stock Options
In the United States, compensatory stock options come in two flavors–incentive stock options (ISOs) and nonstatutory stock options (NSOs). ISOs may result in preferential tax treatment for the option holder. However, in order to qualify as an ISO, the stock option must satisfy specific requirements of the Internal Revenue Code. In particular:
- ISOs must be granted under an equity plan that has been approved by the company's stockholders and that has a limit on the maximum number of shares that may be issued subject to ISOs;
- ISOs may only be granted to employees (options granted to non-employee directors, consultants and advisors are necessarily NSOs);
- ISOs must have an exercise price per share that is no less than the fair market value per share of the underlying stock as of the date of grant (110% if the employee is a 10% stockholder);
- ISOs must have a term of no more than 10 years (5 years if the employee is a 10% stockholder);
- The value of the shares that become first exercisable in any calendar year (calculated using the grant date fair market value) may not exceed $100,000;
- ISOs must be nontransferable; and
- ISOs must be exercised while the option holder is an employee or within three months of the end of employment (or 12 months, if employment ends as a result of death or disability) to receive the beneficial tax treatment.
NSOs don't have the same restrictions. However, to avoid significant adverse tax consequences to the option holder, it is generally the case (as described above) that an NSO has an exercise price per share that is at least equal to the fair market value per share of the underlying stock on the date of grant.
If the option is an ISO, there is no regular federal income tax at grant, as the option vests, or at exercise. If the option holder holds the stock received upon exercise until a date that is more than two years from the date of grant and one year from the date of exercise of the option, the diﬀerence between the sale price and the exercise price will be long-term capital gain (or loss). If either of those holding periods is not met, then at the time the stock is sold the option holder will have compensation income equal to the diﬀerence between the fair market value of the stock at exercise and the exercise price—or the option holder’s proﬁt, if less—and any proﬁt in excess of that amount will be capital gain. While the exercise of an ISO is not an income event for regular federal income tax purposes, note that the diﬀerence between the exercise price and the fair market value of the stock at exercise is income for alternative minimum tax (AMT) purposes and may be subject to state taxes.
If the option is an NSO, there’s no tax at grant or as the option vests. The option holder will have compensation income equal to the diﬀerence between the exercise price and the fair market value of the stock on the date of exercise and, upon sale of the stock, will have capital gain (or loss) equal to the diﬀerence between the sales proceeds and the value of the stock on the day of exercise. This capital gain (or loss) will be long-term if it was held for more than one year and otherwise will be short-term.
Stay tuned for the second of this four-part series in which we explore early exercisable stock options.