How Do Stock Options Work?
For most high growth emerging technology startups, equity is cheaper than cash when it comes to compensating employees. Additionally, many workers in the tech industry desire the ability to reap the benefits of their hard work by sharing in the startup’s upside potential. In order to achieve these goals, most technology startups offer stock options to their employees and service providers. Below is a primer on stock options.
What Stock Options Are
A stock option is a type of security that corporations may issue to their employees and service providers as consideration for the performance of services. A stock option contains an exercise price that is valid for the term of the stock option, thus allowing the recipient to lock in the price of their stock today regardless of whether the price increases over time. A stock option must be exercised in order for the recipient to receive the underlying stock, meaning the stock isn’t free, but typically the exercise price per share is at a low enough value that the recipient doesn’t have to make an exorbitant cash outlay in order to receive the underlying shares.
What Stock Options Are Not
Stock options are not, in and of themselves, shares of your company’s stock. A stock option is a right to purchase shares of stock at the exercise price set forth in such stock option. This means before a stock option is exercised for shares it cannot be voted at stockholder meetings, and it does not entitle the holder to any distributions, dividends or other rights reserved only for stockholders. Once the stock option is exercised for shares of stock, then those shares may be voted and the holder will be entitled to all rights of the holders of the same class of stock. Stock options are also not tax-free. A recipient of a stock option will not recognize any tax at the time it is granted, but depending on whether the stock option is an ISO or NSO (described below), the recipient may have to recognize a tax event at the time the stock option is exercised. Additionally, a tax event also occurs when a recipient later sells the underlying stock after exercise of the option.
Structuring Your Stock Option Program
It is important to note that only corporations can offer stock options. LLCs and partnerships can structure equity incentive programs, but they are not stock option programs, and this article assumes we are dealing solely with corporations.
When structuring your stock option program, common stock should be the class of stock underlying your stock options. There are a few reasons for this: (i) if your company has issued preferred stock to investors, that preferred stock will contain special rights and preferences over the common stock, and your employees and service providers should not receive those same rights and preferences for stock they are receiving in exchange for services; and (ii) it is generally favorable to keep the value of your common stock as low as possible for as long as possible, giving the founders and stock option grant recipients the most possible upside in their shares. It is for this second reason that most startups take on a bifurcated capital structure when raising money from investors – with the common stock staying primarily in the hands of the founders, key employees, and service providers and preferred stock being offered to investors. Because of differences in voting rights, liquidation preferences, and other key features of preferred stock, a startup can typically justify (for tax and other purposes) selling its preferred stock at a higher valuation, and maintaining a lower valuation for its common stock. This lower valuation for the common stock allows the startup to entice service providers with stock options that carry low exercise prices, allowing such service providers to buy into equity at a low valuation and maximize their upside potential in the enterprise.
The Equity Incentive Plan
When you determine that your startup should have a stock option program for incentivizing employees and service providers, your startup’s board of directors will approve the equity incentive plan for the company.
The equity incentive plan is like the handbook for your company’s stock option program – it sets forth the number of shares reserved for issuance as stock options, who may administer the plan (usually the board of directors), who may receive stock options, how stock options may be exercised and paid for, what happens to stock options upon a sale of the company and a host of other issues.
Issuing Stock Options
Once the equity incentive plan is in place, the startup may begin issuing stock options to its employees and service providers. All stock option grants should be approved by the board of directors, which will set the fair market value of the stock options and determine other key terms of the stock option grants, such as the vesting schedule (usually with recommendations from the CEO). After a stock option has been granted by the board of directors, the recipient of the grant should execute a stock option agreement, which will, among other things, recite the date of grant, number of option shares granted, exercise price, termination date of the stock option, vesting schedule and the vesting commencement date. The stock option agreement will also contain a summary of the key provisions of the equity incentive plan and the paperwork necessary to eventually exercise the option.
ISO vs. NSO
There are two kinds of stock options – Incentive Stock Options (“ISOs”) and Non-Statutory Stock Options (“NSOs”). ISOs may only be offered to employees, while NSOs may be offered to any service providers. The difference between ISOs and NSOs has to do with their tax treatment. The main benefits of an ISO over an NSO are that the option holder can: (i) delay any tax events for the option holder until the stock is actually sold by the option holder (instead of at the exercise of the option- as is the case with NSOs); and (ii) if the required holding periods have been met, receive long-term capital gains treatment for taxable gain once the stock is sold by the holder (instead of tax at ordinary income tax rates- as is the case with NSOs).
Because ISOs come with some tax benefits for which NSOs don’t qualify, there are of course additional restrictions on ISOs that are beyond the scope of this article and will be covered separately. For now, the main thing to remember is that ISOs carry added tax benefits over NSOs, and ISOs may only be granted to employees of the startup.
Creating and managing a stock option program can be fairly tricky, as stock options touch on general corporate governance issues, securities issues and tax issues. If you are contemplating the creation of a stock option program for your startup, you should work closely with your startup’s corporate/securities counsel to develop and implement the plan.