Stock Option Plans
Attracting and retaining employees is particularly challenging for a small start-up company. Many such businesses will not have the cash for competitive salaries and benefit packages. An increasingly popular option is to offer employees a lower base salary than their talents may demand elsewhere, but supplement this figure with stock in the company. This strategy has a number of advantages:
- Diverts more cash to research and development;
- Aligns the interest of employees and investors; and
- Attracts the type of employee needed by a start-up, those who are willing to invest themselves in the hopes of making the business, and themselves, successful.
Designing and implementing a stock option plan implicates a number of complex financial and tax issues. Such a project should involve appropriate qualified professionals. However, a general overview may be helpful. A company stock option plan must set forth:
- The number of shares that may be bought;
- Type of stock option;
- The exercise price;
- The duration of the option;
- Permitted form(s) of payment; and
- Any limitation on the purchase or transfer of stock.
The Number of Shares
Shareholders of a company will approve a formal stock option plan, establishing a pool from which options are granted. The business must be careful to manage this pool carefully to ensure adequate stock for grants to employees, directors, advisors, etc. Twenty percent (20%) is a sensible portion of the pool to dedicate for issuance to employees and service providers. In making these calculations, stock issued at formation is excluded.
The Type of Stock Option
The stock option plan should set forth whether a grant is an incentive stock option or nonqualified stock option.
For the most part, options should be granted at an exercise price equal to the fair market value of the stock as of the date of the grant.
Incentive Stock Options are limited to a term of ten years or less. This is a common maximum term for stock option plans.
Permitted Form(s) of Payment
Most stock option plans allow all or a combination of the following forms of payment:
- Cash, or cash equivalents;
- Currently owned shares of company stock;
- Proceeds from the sale of stock upon immediate exercise; and
- Promissory note.
Restrictions on the Purchase or Transfer of Stock
Most stock option plans establish a period of time during which an employee must work before options will "vest." Vesting provides a "contractually unrestricted" right to purchase stock when the option is exercised. Terms vary, but many stock option plans vest after four years, vesting not at all for the first year, and vesting in equal installments monthly until complete.
Vesting may also be tied to performance goals. Unfortunately for employers, this practice has the potential for adverse accounting consequences.
A stock option plan may allow the employee to exercise an option immediately, even if this results in the acquisition of unvested shares. In some instances this practice may offer tax advantages.
A popular option for private companies, due to its relative administrative simplicity, is to restrict the exercise of options to vested shares.
As part of its stock option plan, a company must decide whether it wants to retain control over the ownership of its shares by giving itself the right to reacquire shares owned by an optionee who wishes to transfer ownership before the stock is publicly traded, or to reacquire even vested shares upon the optionee's termination.
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