Founders Series: Stock-Based Compensation – Part II

In the first post examining stock-based compensation issues, we explored key elements of restricted stock . We now turn to an examination of the types and uses of stock options.

Stock Options

A stock option is a right to buy stock in the future at a fixed price (i.e., the fair market value of the stock on the grant date). Stock options are generally subject to the satisfaction of vesting conditions, such as continued employment and/or achievement of performance goals, before they may be exercisable.

There are two kinds of stock options:

1) Incentive Stock Options (ISOs)

2) Non-Qualified Stock Options (NQOs).

ISOs are a creation of the tax code, and, if several statutory requirements are met, the optionee will receive favorable tax treatment. Because of this favorable tax treatment, the availability of ISOs is limited. NQOs do not provide special tax treatment to the recipient. NQOs may be granted to employees, directors and consultants, while ISOs may only be granted to employees – not to consultants or non-employee directors.

Generally, there is no tax effect to the optionee at the time of grant or vesting of either type of option. Regardless of whether an option is an ISO or an NQO, it is very important that an option’s exercise price be set at not less than 100% of the fair market value (110% in the case of an ISO to a 10% stockholder) of the underlying stock on the date of the grant in order to avoid negative tax consequences.

Upon exercise of an ISO, the optionee will not recognize any income, and if certain statutory holding periods are met, the optionee will receive long-term capital gains treatment upon the sale of the stock. Upon exercise, however, the optionee may be subject to the alternative minimum tax on the “spread” (i.e., the difference between the fair market value of the stock at the time of exercise and the exercise price of the option). If the optionee sells the shares prior to meeting such statutory holding periods, a “disqualifying disposition” occurs. In this event, the optionee will have ordinary income at the time of sale equal to the “spread” at the time of exercise plus capital gain or loss equal to the difference between the sale price and the value at exercise.

If the shares are sold at a loss, only the amount of the sale in excess of the exercise price is included in the optionee’s income. The company will generally have a compensation deduction upon the sale of the underlying stock equal to the amount of ordinary income (if any) recognized by the optionee if the holding period described above is not met, but the company will have no compensation deduction if the ISO holding period is met.

At the time of exercise of an NQO, the optionee will have compensation income, subject to tax withholding, equal to the option’s “spread” and taxable at ordinary income rates. When the stock is sold, the optionee will receive capital gain or loss treatment based on any change in the stock price since exercise. The company will generally have a compensation deduction at option exercise equal to the amount of ordinary income recognized by the optionee.

For start-up and early stage companies, stock options create significant incentives for executives and employees to drive the company’s growth and increase the company’s value, because stock options provide optionees the opportunity to share directly in any and all up-side above the option’s exercise price. These incentives also serve as a strong employee retention tool.

On the other hand, stock options limit or eliminate most down-side risk to the optionee, and, in certain circumstances, may encourage riskier behavior. Additionally, it may be difficult to recapture the performance incentives that stock options provide if the value of the stock falls below the option exercise price (i.e., the options are “underwater”).

In many cases, an employee will not exercise an option until the time of a change in control, and, while not the most tax efficient result for the optionee (all proceeds will be taxed at ordinary income tax rates), this delayed exercise will permit the optionee to recognize the full spread of his or her award with little or no down-side risk.

Start-up and early stage companies may also elect to grant so called “early-exercise” or “California style” options. These awards, which are essentially a hybrid of stock options and restricted stock, permit the grantee to exercise unvested options to purchase shares of restricted stock subject to the same vesting and forfeiture restrictions.

Stay tuned for our next post looking at stock-based compensation considerations!

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