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.
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.
Before we go further, it’s important to understand the key terms involved in stock options:
A couple of other terms relating to types of stock that should be understood by anyone starting a new venture are discussed below.
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.