TIPS AND PITFALLS REGARDING STOCK OPTION PLANS
TYPES OF PLANS
With stock options the goal is to allow the
employees to benefit from increases in the value of the company’s stock.
Specifically, the idea is that the employee will receive the difference between:
the exercise price for the options and
the price received from the employee’s later
sale of the stock.
The board of directors establishes the amount of
stock that will be set aside for the options, determines from time to time which
employees will receive options and the exercise price, and–if there is a
buy-back obligation--periodically determines the value of the stock in good
faith (unless of course the stock is publicly traded).
Employee stock options are generally one of two
types: Incentive Stock Options (ISOs)–which must comply with certain federal
statutory requirements--and Nonstatutory Stock Options (NSOs).
A widely used alternative that does not involve
stock options is Phantom Stock (also known as Shadow Stock or as Stock
Appreciation Rights or SARs, though technically the latter is a bit different).
With Phantom Stock an employee receives not stock but contractual "units"
that allow the employee to receive payments based on increases in the
DIFFERENCES BETWEEN ISOs AND NSOs
One difference between ISOs and NSOs is that ISOs
can only be granted to employees. NSOs can be granted not only to
employees but to independent contractors, non-employee directors and others.
The primary difference, though, between ISOs
and NSOs is the tax consequence to the employee and tax deductibility for the
company. ISOs are often more favorable to the employees in terms of taxes, and
NSOs are often more favorable to the company.
Generally, startups and growing companies that
have not gone public prefer to use ISOs because of the additional benefits that
they provide employees. (Companies that have already gone public tend to favor
NSOs.) Also, if a company does not expect to have taxable income during the
stock-option period (because, for example, salaries and bonuses are expected to
consume all the profits), an ISO may make more sense for the company since it
would not be able to take advantage of NSO deductions anyway.
NSOs AND TAXES
With an NSO, the employee is taxed at
the time he/she exercises the option on the difference ("spread")
between the amount the employee paid for the stock (the exercise price) and the
value of the stock at that time. (For example, the employee could have the right
to buy the stock at $2 a share but the stock might be worth $3 a share at the
time he/she exercised the option, so the "spread" is $1.) The employee has
to pay tax on the spread even though he/she does not immediately sell the stock,
but holds it.
Moreover, with an NSO the employee is taxed at ordinary
tax rates on the spread. This obviously can be hard on the employee if
there is a significant spread and the employee wants to hold onto the stock
rather than sell it immediately. Also, when the employee exercises an NSO, both
the company and the employee owe withholding
taxes on the spread. (An NSO agreement should expressly cover the subject
of how payment will be made for the employee’s share of the withholding.) On
the other hand, with an NSO the company receives
a tax deduction equal to the amount of income the employee recognizes on
ISOs AND TAXES
In contrast, with an ISO the employee does NOT
pay taxes at the time the option is exercised as long as certain conditions are
met. (And neither the employee nor the company pay withholding.) Instead, the
employee is taxed only when he/she sells the
Also, if the employee holds the stock at least
two years from the grant date and one year from the exercise date, the spread is
taxed at the lower capital gains rate. On the other hand, the company does not
receive any tax deduction.
A major exception to the generally favorable
tax treatment that an ISO offers employees is the Alternative Minimum Tax. The
Alternative Minimum Tax applies to any spread between the exercise price and the
fair value of the stock at the time the option is exercised. The Alternative
Minimum Tax is too complicated to be discussed here, but generally it affects
people with incomes over $75,000 (although there are a number of variations
depending on the employee’s individual tax situation). Any employee with
income in that range should obtain tax advice concerning his/her options.
Assuming the Alternative Minimum Tax applies, an employee may want to make sure
that after exercising an option he/she sells enough of the stock to cover the
Alternative Minimum Tax.
For a stock-option plan to qualify as an ISO, the following requirements must
be met. The list is important because if the company does not want to meet any
of these requirements it needs to consider an NSO or Phantom Stock Plan instead.
To qualify as an ISO the plan must meet the following requirements:
participants must be employees of the company.
For an employee to receive capital gains tax
treatment, the shares cannot be sold or transferred within 2 years from the date
of the granting of the option nor within 1 year after the exercise of the
option, and the options must be exercised no later than within three months of
termination of employment.
The plan must designate the total number of
shares which may be issued under the plan and the employees (or class of
The company’s shareholders must approve the
plan within 12 months before or after the plan is adopted.
All options must be granted within 10 years of
the date when the plan was adopted, or the date the plan was approved by the
shareholders, whichever is earlier.
The options must not be exercisable more than
10 years from the date each was granted.
The option price must not be less than the fair
market value of the stock at the time the option was granted.
The options must not be transferable except by
death, and may be exercised only by the employee who was granted the options (or
No recipient of
the options may own stock possessing more than 10 percent of the total combined
voting power of all classes of stock of the company or any parent or subsidiary
companies UNLESS the exercise price for such employees is at least 110% of the
fair market value of the stock AND the option is not exercisable after the
expiration of five years from the date the option is granted.
To the extent that the aggregate fair market
value of stock with respect to which options are exercisable for the first time
by the recipient during any calendar year (including plans of the company’s
parent and subsidiaries) exceeds $100,000, those options in excess of $100,000
are treated as NSOs, not as ISOs.
SECURITIES ISSUES WITH STOCK OPTIONS
Because stock options are securities, they are
governed by federal and state securities laws, which impose certain
On the federal level, stock options (both ISOs
and NSOs) are exempt from federal securities registration if there is a written
stock-option plan, and the options to be sold within any 12-month period do not
exceed the greater of i) $1 million, ii) 15% of the company’s assets, or ii)
15% of the then-outstanding class of stock that is being used for the options.
If the company intends to provide options for more than $5 million in stock, the
company must provide specific disclosures to each person receiving the options.
CALIFORNIA REQUIREMENTS FOR STOCK OPTIONS
If you have fewer than 35 participants, you can
use the (easy) 25102(f) exemption, assuming you meet the 25102(f) requirements.
All participants must either:
Have a pre-existing personal or business
relationship with your company or any of its officers/directors/managers that
would enable a reasonably prudent purchaser to be aware of your character,
business acumen and general business and financial circumstances; or
Have the capacity to protect their own interests
in connection with the transaction, by reason of their business or financial
experience or that of their professional advisors.
California requires the filing of form 25102(o) within thirty days of the
issuance of the first stock option, and also requires the following for both
ISOs and NSOs. Stock option plans that use the 25102(o) exemption must meet a
California list of requirements. Again, this list is important in the sense that
if you do not want to comply with all of the restrictions you probably should be
looking at a Phantom Stock Plan instead. (Other states, of course, may have
their own requirements.) Many of these requirements are similar to the federal
requirements for ISOs, except these apply to
both ISOs and NSOs:
price must not be less than 85% of the fair value of the stock at the time the
option is granted, EXCEPT that the price must be 110% of the fair value in the
case of any person who owns more than 10% of the total combined voting power of
all classes of stock of the company.
The exercise period must last no more than 120
months from the date the option is granted.
The options must not be transferable except by
death or by gift to "immediate family".
The right to exercise must be at the rate of at
least 20% per year over 5 years from the date the option is granted, subject to
reasonable conditions such as continued employment. However, in the case of an
option granted to officers, directors or consultants, the option may become
fully exercisable, subject to reasonable conditions such as continued
employment, at any time or during any period established by the company.
Unless employment is terminated for cause, the
right to exercise in the event of termination of employment (to the extent that
the optionee is entitled to exercise on the date employment terminates) must be
At least 6 months from the date of termination
if termination was caused by death or disability.
At least 30 days from the date of termination
if termination was caused by other than death or disability.
The plan must have a termination date of no more
than 10 years from the date the plan is adopted or the date the plan or
agreement is approved by the stock holders, whichever is earlier.
Shareholder approval of the plan must occur
within 12 months before or after the date the plan is adopted.
holders must be provided with financial statements at least annually.
If provisions give the company the right to
repurchase stock upon termination of employment, the repurchase price will be
presumptively reasonable if:
it is not less than the fair market value of
the stock on the date of termination of employment, AND the right terminates
when the issuer's stock become publicly traded, AND the right to repurchase must
be exercised within 90 days of termination of employment (or in the case of
stock issued upon exercise of options after the date of termination, within 90
days after the date of the exercise); OR
it is at the original purchase price, PROVIDED
that the right to repurchase at the original purchase price lapses at the rate
of at least 20% of the stock per year over 5 years from the date the option is
granted AND the right to repurchase must be exercised within 90 days of
termination of employment (or in the case of stock issued upon exercise of
options after the date of termination, within 90 days after the date of the
In addition to the restrictions set forth in (1) and
(2), the stock held by an officer, director or consultant of the company may be
subject to additional or greater restrictions.
The stock that is
being optioned carries the same voting rights as the company’s common stock.
PHANTOM STOCK PLANS
As mentioned above, Phantom Stock differs from
stock options in that the employee does not ever receive actual stock. (As
mentioned above, Phantom Stock is also known as Shadow Stock or Stock
Appreciation Rights or SARs, though there are some minor differences with the
Some companies prefer Phantom Stock plans so
that they do not have large numbers of small shareholders (which investors
typically dislike) and do not have to worry about employees affecting the
election of directors, voting on decisions to sell the company, voting on
efforts to establish other classes of stock etc.
Essentially, a Phantom Stock Plan provides an
employee with a contractual bonus based on the increase in the value of the
company’s shares–or on a formula such as increases in profits or revenues.
Rather than options, the employee receives "units". The bonus, which is subject
to withholding, is taxed as ordinary
income to the employee at the time it is received. The company receives a
deduction for the amount of the payment. On
the other hand, the employee does not have to worry about selling stock for
which there may not be a market. (Of course, a stock-option plan can
always have a provision requiring the company to repurchase the stock if certain
conditions are met, but many companies are reluctant to undertake this
FLEXIBILITY IN PHANTOM STOCK PLANS
Phantom Stock Plans offer much more flexibility
than stock-option plans and can be structured in a variety of ways. Often
employees are given a certain number of units. Each unit may have the same value
as a share of the company’s stock on the date the unit is issued. After a set
number of years (to encourage employees to stay with the company)–or upon
death, retirement or sale of the company–the employee receives a bonus equal
to the increase in the value of the company’s stock. Alternatively, the bonus
can be based on increases in the company’s revenues or profits. Often the
payout is made over several years (with interest) to ease cash-flow issues for
the company. Another option is to pay the employee the increase in value
Phantom Stock is not considered a security and
therefore no securities filings are required.
CHOOSING THE RIGHT PLAN
In choosing an incentive plan, the company
should consider whether it needs the additional incentive effect that an ISO
offers–and if it is willing to comply with the federal requirements for an
ISO. (Also, if the company is not projecting profits for some time, this makes
an ISO more attractive.)
If the company is not willing to comply with
the ISO requirements or it wants deductions, the company (assuming it is a
California company) should examine whether it is willing to comply with the
California requirements for stock-option plans. If so, an NSO may be appropriate
if the company feels its employees would feel more incentive if they have stock
options or stock rather than cash.
If the company wants more flexibility that
stock-option plans offer–or does not want the potential problems that may come
from employees owning stock in the company--the company probably is going to
want to establish a Phantom Stock plan.