Stock options, post #13, “Startup Briefs”

Too many entrepreneurs don’t understand stock options: how they work, when to issue them, and to whom. Let’s demystify stock options.

What you need to understand at first is that stock options are an alternative to regular stock grants. As discussed in a previous post, Funding the nitty gritty, post #6 of “Startup Briefs,” I recommend that the first stock grants to founders take the form of restricted stock so that the person receiving the grant is tied to the company by time. BUT, this type of grant is restricted by valuation. Once you have added value to your company, say by revenues or raising money, then there is value to those stock grants, and the tax man will expect his share. Restricted stock is only valid for the founders, or maybe early employees, who receive stock that is technically worthless at the grant. More discussion of restricted stock can be found towards the end of this post where restricted stock and phantom stock are defined as bonus incentives.

Stock options are a way to defer taxation until the options are exercised and turned into shares. Say you have raised a small amount of seed money and are ready to bring on your first full-time employee. You want her to buy into your vision and be a part of the team – to row in the same direction as the rest of you. As part of her package you want to grant her stock. This will likely be in the form of stock options. And you don’t just grant options. First, you have to have an agreement for how this will function in your company for all employees.

Definition: A stock option in the startup world can be defined as: a contract between two parties in which the stock option buyer or recipient purchases or is granted the right (but not the obligation) to buy shares of an underlying stock at a predetermined price from the option holder or seller within a fixed period of time. A stock option in the startup world is different than in the publicly traded world where you can buy an option to buy or sell shares at a fixed price within a certain time frame.

Options are either incentive stock options (ISOs) or nonqualified stock options (NSOs). Both are defined below.

• An ISO is only for employees of a company. An ISO enables an employee to: 1) defer taxation on the option from the date of exercise until the date of sale of the underlying shares, and 2) pay taxes on his/her entire gain at capital gains rates, rather than ordinary income tax rates. Certain conditions must be met to qualify for ISO treatment, such as how many shares you can exercise, the timeframe within which you can exercise, and so on.
• NSOs can be offered to anyone, including outside directors and consultants. NSOs result in additional taxable income (ordinary taxable income) to the recipient at the time that they are exercised, the amount being the difference between the exercise price and the market value on that date. They are also tax deductible at the time of the option exercise to the employer. Many entrepreneurs and lawyers agree that NSOs can be simpler to implement.

A company can have both ISOs and NSOs although this gets more complicated and expensive to set up for startups. Whatever type is preferred, the company needs a stock option plan. This is the benefit plan approved by shareholders (usually represented by the board) which makes the recipients of stock option grants owners of stock in the company. While examples of such plans are readily available if you search, I recommend that you use your lawyer to create the right plan for you. The plan will outline the grant date, expiration date, vesting schedule, and exercise price. The plan can include provisions for both types of stock options. A startup may elect for an NSO plan to compensate directors and consultants and other non-employees. But, the same company may also elect to have an ISO for executives and employees. The plan governs all of the stock option logistics. Entrepreneurs need to understand when they need a plan, and they need to allow the time, money and effort to setup such a program.

Definitions

Before we go further, it’s important to understand the key terms involved in stock options:

• Grant date. This is the date that of the contract whereby the stock options are granted to the individual. On this date, the employer no longer reserves the right for its employee to purchase company stock under the terms of the stock option agreement.
• Expiration. This is the ending date at which the stock options much be exercised.
• Vesting. This refers to the specific schedule (the vesting schedule) by which the stock options become able to be exercised. Remember that the option recipients are typically not granted full ownership of the options on the grant date.  For example, an employee is granted 1200 shares, but only 300 are immediately granted. The rest may be equally divided by year, depending on whether the person is still with the company. Thus, assuming a typical three-year vesting period, the person receives an additional 300 shares after one year of service, another 300 after two years, and the final 300 shares after three years.
• Exercise. A stock option is granted at a specific price, known as the exercise price, also sometimes referred to as the strike price. Either way, it’s the price per share that a person must pay to exercise his/her options. The exercise price is important because it is used to determine the gain and the tax payable on the contract. The gain is calculated by subtracting the exercise price from the market price of the company stock on the date the option is exercised. The whole point here is the underlying assumption that the exercise price today will be lower than the actual stock price tomorrow.

A couple of other terms relating to types of stock that should be understood by anyone starting a new venture are discussed below.

• Restricted stock. Restricted stock grants employees the right to purchase shares at fair market value or a discount. Sometimes restricted stock is granted outright to individuals – often founders. However, the shares are not really yours yet; you don’t own them until specified restrictions lapse – hence the term “restricted” stock. Usually vesting of restricted stock occurs over time, typically three to five years. Besides time, other restrictions could be imposed, such as performance goals. Restricted stock ties the employee to the company over time, much like stock options, but in reverse. Like options, the employee needs to continue working at the company to vest their shares. BUT, the shares are granted at the top of the vesting period. I’ve seen this used most effectively among co-founders. Having made the mistake myself of granting founders shares to co-founders who ended up not staying with the startup, I’ve learned to use restricted stock to keep all co-founders committed to the company. If they don’t stay, fine. They only take their vested shares with them when they leave. If they were granted 20% of the company upon founding and they leave after only one year, they walk away with 5%, which is a whole lot better than 20%. Restricted stock is taxed at market value. At founding, company shares are worth about $0, meaning tax at the time will be minimal. When employees/founders receive restricted stock, you should consider a “Section 83(b)” election to avoid serious tax consequences that can occur as the stock price rises over time. For example, assuming you paid nothing for your restricted stock, you will be taxed on the value of your restricted stock as determined at grant if you filed a Section 83(b). If you don’t file the Section 83(b), you will be taxed the market value of the stock at the applicable ordinary income tax rate.
• Phantom stock and stock appreciation rights. Phantom stock and stock appreciation rights (SARs) are similar concepts. Both essentially are bonus plans that do not grant stock but, rather, the right to receive an award based on the value of the company’s stock, hence the terms “appreciation rights” and “phantom.” Phantom stock and SARs can be granted to anyone, but, if they are given out broadly to employees and designed to pay out upon termination, they could be considered retirement plans, and thus could be subject to federal retirement plan rules. Careful plan structuring can avoid this problem (read: good lawyering and good accounting). Because SARs and phantom plans are essentially cash bonuses, companies need to have the means to pay for them. The need for planning and cash set-aside can make it challenging for any small, growth-oriented company to use phantom stock or SARs.

Conclusion

Stock is an attractive and necessary incentive for founders, employees and other key individuals. What better way to encourage your team to participate in the growth of a company than by offering each of them a piece of the action? After all, startups have more stock to offer than they have cash. But you need to know who gets what type of stock incentive. Founders should receive restricted stock grants that vest over a period of time. Early employees should probably receive stock options that also vest over time. In practice, setting up the option plans takes time and money. In addition, for the recipient, redemption and taxation of these instruments is complicated. Most employees don’t understand the tax effects of owning and exercising their options. As a result, they can be penalized by Uncle Sam and may miss out on potential financial benefits. Selling employee stock immediately after exercise will induce higher short-term capital gains tax. Waiting until the sale qualifies for lesser long-term capital gains tax can save hundreds or even thousands of dollars. So, entrepreneurs need to enter into this world informed about what the options are – quite literally!

Special thanks for clarifying some of the info in this post goes to Steve Cherin, Cherin Law Offices @CherinLaw.