Whether you are a bricks-and-mortar business or a dot-com, all owners of growth companies need to attract, retain and motivate key management to elevate their businesses to the next level.
As a growth company, using large amounts of cash to achieve this is often not an option. One alternative being utilized more and more is stock options.
There are two types of stock options — qualified (e.g., incentive stock options, commonly referred to as ISOs) and nonqualified. There are numerous factors to consider prior to adopting either type to ensure that both the company granting the options and the employees receiving them can take advantage of the corresponding tax benefits.
There are advantages and disadvantages associated with both. Here are a few of the major differences, including key factors to consider when deciding which type of option to adopt.
Qualified options (ISOs)
- Recipients of the options are taxed at the time of the ultimate sale of the stock acquired on exercise, not at the time the option is exercised, delaying tax liability.
- Recipients are taxed at the capital gains rate rather than at the ordinary income rate, assuming the minimum statutory holding requirements are met.
- ISOs are limited in the amount of stock that can become exercisable in any calendar year.
Nonqualified options
- These are not limited in the amount of stock that can be awarded on an annual basis.
- They allow the company issuing them to take a tax deduction for employee compensation.
- Recipients are taxed on the appreciation in value of the stock at the time the option is exercised, rather than at the time of the ultimate sale of the stock. This may leave the employee with an income tax liability with no means to pay for it if the stock is not sold at the same time the option is exercised.
- Recipients are taxed at ordinary income tax rates on the appreciation.
Regardless of the type of plan implemented, there are several issues to keep in mind when evaluating and adopting a stock option plan.
Size of the option pool. While there is no hard and fast maximum amount, many companies typically set aside 10 to 20 percent of the equity to be granted to key management and employees. When calculating the total percentage to be allocated for the option pool, don’t forget to account for future employees who will be hired to round out the management team.
Awarding the options. Typically, options are awarded based on performance measures that will result in the company achieving its overall business strategy and growth/profit goals. The primary goal of options is to use equity ownership to align the interests of employees with those of the company and to motivate employees to reach the company’s long-term goals.
Vesting of options. Typically, options will vest (become exercisable) over a period of time. By utilizing a vesting schedule spread over several years, companies can lock in key employees. However, the plan or the option should also include forfeiture provisions in case an employee leaves before the options vest.
Stockholders’ agreement. Recipients of the options should be required to execute a stockholders’ agreement at the time of exercise of the options. This may contain a number of restrictions on the stock (e.g. forfeiture provisions, buy-back provisions for the company, restrictions on transfer, etc.) and virtually any other terms the company desires within the bounds of the law.
Noncompetition/nondisclosure agreement. When adopting and implementing a stock option plan, business owners are presented with the perfect opportunity to have their key employees execute a noncompetition/nondisclosure agreement. As a potential stockholder in your company, following exercise, recipients of options will have access to valuable and proprietary corporate information. The noncompetition/nondisclosure agreement serves to protect companies from the potentially damaging scenario of losing a key employee and his or her intellectual capital to a competitor.
Numerous factors and laws govern stock option plans. A company’s decision to implement a plan should be made only after careful consideration of its circumstances and financial position and consultation with legal and tax advisers.
Whatever the route, employers should feel out their key management and employees to see what will motivate them. Employers and employees often have opposite views on this subject.
The goal is to motivate, not aggravate. The good news is that the “options” are many. Lee Koury ([email protected]) is an attorney at Arter & Hadden LLP and a member of the firm’s E-Group and Growth Group. The Growth Group is a multidisciplinary group of attorneys which focuses its practice on entrepreneurs and emerging growth companies. He can be reached at (216) 696-5677 or through the company’s Web site at www.arterhadden.com.
