Choosing an Employee Stock Option

Practice Areas
By Hooman Yavi

It is now common practice in the corporate world to offer stock options to employees. This can be a useful tool, since stock options provide a way for corporations to attract and retain high-performing candidates. In general, stock options align incentives by tying employee compensation to company performance.

Of course, it is in a company’s best interest to oversee an employee’s quality of work. Thus, many stock options are subject to a vesting period. During this vesting period, employees gain access to a larger percentage of their shares each year, until they have full access to their stock options at the end of the period.

Vesting and Exercising Stock Options

Once the stock vests, employees have the right to exercise their stock options. Exercising stock options means that employees can purchase stock from the company at the specified strike price.

The four-year vesting model, also known as time-based vesting, is common. The first year is known as the “cliff period,” when employee performance is tracked. If an employee leaves the company during this twelve-month period, they lose their equity. After these twelve months, all equity gained vests. The employee is placed on a monthly vesting schedule for the remaining three years.

Fast-growing startups may want to steer away from the time-based model. Instead, performance-based vesting can help retain high-performing employees. In this model, stock options only vest once employees meet specific performance criteria. Regardless of which model a corporation chooses, vesting is a financial incentive that encourages mutual success.

Determining Price Per Share

The exercise price is the per share price which the employee must pay to exercises their stock options. It can be full market value (FMV), or it can be set to provide employees with a discount. However, for the stocks to qualify as Incentive Stock Options (ISOs), they must be set to FMV. Otherwise they will not qualify for preferential tax treatment.

If this requirement is violated, employees are required to pay a 20% penalty tax (Section 409A, Internal Revenue Code). However, the IRC’s safe harbor valuation method guides corporations on how to avoid this situation.

Different Stock Options Available

There are five main forms of equity that can be offered to employees. There are a number of differences between them.

Stock Option Type

Pros

Vesting & Exercising

Cons

Incentive Stock Options (ISO)

  • Popular with employers

  • Substantial tax benefits, but with restrictions

Employees should hold stock for 2 years after it vests, and 1 year after it is exercised, before selling stock

If the employee does not wait three years, they are not eligible for long-term capital gains tax, capped at 20%.  Instead profits can be taxed as ordinary income (as high as 39.6%).

Employees take substantial risk by holding their stock for three years

Non-qualified stock options

·         Lower risk for employees than ISO

Once the NSO vests, employees have a period when they can exercise the stock – also known as the expiration date.

Stock is taxed as ordinary income once exercised (“income” is the difference between the exercise and grant price of the stock).

If employees do not exercise their stock before the expiration date, they forfeit all rights to it.

NSO are not as tax-friendly as their ISO counterparts.

Restricted Stock

·         Stock ownership

·         Voting rights

The 83(b) election allows employees to pay income tax on the price of the stock when granted. Later, when the stock is sold, employees must only pay long-term capital gains tax on profit.

If employees do not to file an 83(b) election, the stock gets taxed as ordinary income once it vests, and an additional capital gains tax is applied when it gets sold.

It could cost employees more if they don’t file an 83(b) election since stock price often appreciates over time.

Stocks are restricted. Employees cannot transfer or sell their shares unless they wait out the restricted period.

Once the restricted period passes, the company’s right to buy back the stock lapses and the employee can exercise them.

Restricted Stock Units

·         Preferred stock option of employees

·         If the stock price falls after it is granted, the overall value of the stock is still dependent upon the price at vesting

·         RSUs always have value

·         Taxed differently from ISO and NSO – employees pay income tax when the stock vests, thus they pay taxes on a smaller sum of money

Once the vesting period is complete, the company awards employees with either the right to the shares or the cash equivalent of the shares.

Employees that receive RSUs do not hold equity or ownership within the corporation. Since RSUs are essentially considered to be “right to stock,” it is not eligible for an 83(b)-election form. Rather, when an RSU vests, it is taxed as ordinary income.

When employees sell their shares, the capital gains tax is applied on the acquired income.

Shares are not issued until the stock vests.

Phantom Stock (Shadow stock)

·         Gives a limited number of employees the benefits of owning stock without providing them with company stock

·         Good for employers to attract high-performing talent without diluting stock

·         Ownership rights

There are two types of phantom stock: 1) appreciation-only and 2) full-value.

Under appreciation-only phantom stock, employees get paid the difference between the current value of the stock and the initial value of the stock, per granted share.

Under full-value phantom stock, employees get paid the stock price upon vesting, per granted share.

The company pays the accumulated profit in cash; rarely are the granted shares translated into stocks. the stock only gets taxed as ordinary income upon exercise. For phantom stocks, “income” is the difference between the exercise price and the consideration price.

Phantom stock can come with additional costs to employers, such as valuation.

Stock Appreciation Rights (SARs)

·         Like Phantom Stock, gives limited employees the benefits of owning stock but does not actually give them stock

·         Ownership rights

The stock can be paid in cash or shares.

·         Cash: same process as phantom stock

·         Shares: must pay capital gains tax on the profit acquired after exercise

Payments are not equivalent to the company’s dividends, or the stock’s actual value

Conclusion

Stock options offer substantial benefits to both employers and employees, as they give employees a reason to be committed to company performance. Stock option features vary, and each may be a good fit for different companies. We recommend getting in touch with your trusted Chugh, LLP attorney for advice on your specific situation.

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