Hands On: Stock Options

In a private company, there's more than one way to structure your plan

No doubt about it: stock options can be tricky. But in today's tight labor market, many entrepreneurs who own private companies conclude that they need to offer stock options to compete for top talent. Just ask Dick Plodzien, CEO of the Spencer Reed Group Inc., a privately held executive-search and staffing company based in Overland Park, Kans. Not long ago, Plodzien, whose fast-growing company had $15.6 million in 1996 sales, established a stock-option plan to attract and keep employees. Plodzien says big companies have been poaching from his staff, and he hopes options will help him retain employees. "It's like a poison pill that keeps away the competition," he says. He claims that options also helped him persuade three executives to leave billion-dollar-plus corporations to join Spencer Reed, which has plans to go public in the next few years. "I wanted to give them a piece of the action," he says. "It's important in attracting people of a certain caliber."

You know the pros and cons of stock options. You've considered the caveats. Yet maybe, like Plodzien, you also know that a stock-option plan could help your growing but private company attract the talent you need--so you've decided to install one, anyway. The next question is, What's the smartest way to do it?

Designing an option plan has a lot in common with shopping for a new car. There are some basic models to choose from and then some enhancements to consider. Don't make any decisions without taking Inc.'s quick tour of the options "shop floor."

Which models are most popular with private companies?
When setting up an option plan, private companies tend to choose either nonqualified plans or incentive stock options (ISOs). (Technically, ISOs are a form of qualified options, and you may hear them described that way.) Both nonqualified stock options and ISOs confer upon recipients the right to buy stock within a certain time frame at a specified price. The appeal comes from the difference between that price--called the exercise price--and the stock's appraised or fair market value.

That's where their similarities end. Nonqualified plans and ISOs have quite different tax implications, both for option recipients and for companies themselves.

What are the tax differences?
Let's look at nonqualified plans first. As long as your company designs its plan properly, the employees who receive nonqualified options won't owe taxes on their options until they exercise them. Here's how the tax situation should work: "Let's say the value of your company is $5 per share and you've given an executive 1,000 options with an exercise price of $3," explains Ralph Anderson, a partner at the Florham Park, N.J., office of accounting firm Richard A. Eisner & Co. LLP. "If she exercises those options now, she will owe ordinary income tax on $2,000." That's because $2,000 is the amount by which the stock's current value exceeds the exercise price. At that point, your company also qualifies for a tax deduction of the same amount. If, after exercising the option, your executive holds on to the stock for a while and it appreciates, she will owe only capital-gains tax on that appreciation when she sells.

What about ISOs? If they are structured properly, the option holder won't owe any ordinary taxes when he or she exercises the options. The bad news: there's also no corresponding corporate deduction. (One caveat: in some circumstances, particularly those involving highly compensated employees, a gain on an ISO can end up meaning that the recipient owes alternative minimum tax, or AMT, that year. Check with your accountant on that one.)

With ISOs, the employees' taxes don't come due until the exercised shares are sold. Then the stock appreciation is subject to capital-gains tax rather than ordinary income tax. But if you choose to go with ISOs, warn your employees to keep an eye on the calendar. To qualify for that sweet tax deal, they can't dispose of the stock within two years after the time the option was granted--and they also can't sell stock within one year of the time they exercise the option.

Which plan should I choose?
Talk to a good lawyer and a good accountant about that decision. But in general, if your company needs the benefit of a big tax deduction, look into a nonqualified stock-option plan. If the tax deduction doesn't matter so much, you may want to explore ISOs. Whichever plan you select, expect to pay $5,000 to $10,000 in combined legal and accounting fees for plan design.

Many companies offer both types of plans. "I was the chief financial officer of a company that had two different kinds of option plans because each one was appealing to a different group," recalls Ken Haffey, now a partner at SMR & Co. Business Services, a financial-business-services firm in Mayfield Village, Ohio. "The president, chairman, and executives all had ISOs, which we liked because taxes could be postponed until the stock was sold--and it was at the lower, capital-gains rate. The directors received nonqualified options, which they preferred because the plan was straightforward and the options didn't bring any AMT complications."

One big advantage of any stock-option plan is its discriminatory nature. Unlike 401(k) retirement plans, stock-option plans allow you to include just those key people whom you want to motivate or reward.

Let's talk enhancements.

According to Dale Peck, a partner at Beers & Cutler PLLC, an accounting firm based in Washington, D.C., there are all kinds of ways that private companies can--and often should--fine-tune their option plans. "Business owners need to pay attention to a lot of technical details when they design their plans," he observes. "One issue that's easy to overlook is how fair market value will be defined." According to Peck, private companies with option plans probably should pay for a valuation once a year. "But you don't want to get into a situation where you wind up needing a new valuation every time someone decides to exercise," he adds.

That's worth a clause in your option plan. Also stipulate that any employee leaving your privately held company must sell back any stock--and have a strong shareholder's agreement in place. Another suggestion from Peck: "If you hope, the way many owners of private companies do, that your employee will buy the stock and hold on to it, you may also want to provide a low- or interest-free loan." A good accountant should help you consider those and a wide range of other possibilities.

Jill Andresky Fraser is Inc.'s finance editor. Additional reporting on this story was provided by Stephanie Gruner.

Analysis: The No-Option Option

Do you really need an option plan? "The majority of private companies can accomplish most or all of their important goals by forgoing options entirely and instead making use of a phantom-stock technique," says Jim Scannella, a principal in Arthur Andersen's human-capital-services group. "It's possible to pass on the same financial reward to executives or others without incurring any of the risks or complications that might accompany the sharing of equity."

Phantom-stock plans (or stock-appreciation rights, which are very similar) can yield the same payoff option plans do. Here's how they work: You give your executive 1,000 shares of so-called phantom stock at, say, $10 a share. The phantom stock is not actual equity but is tied to the value of your company's stock. You schedule a company valuation for some future date. If the valuation shows that your company's stock has risen by, say, $30 a share, you send the executive a $30,000 check. There's no pain-in-the-neck need for him or her to buy and then sell the stock (or, worse still, hold on to it and become a grousing minority shareholder). At tax time, your executive pays taxes on $30,000 worth of ordinary income, while your company qualifies for a $30,000 tax deduction.

You could also combine a phantom-stock plan with some type of stock-option plan. "One client came to me with the goal of incentivizing two groups, one of family members and one of nonfamily executives," recalls Ken Haffey of SMR & Co. Business Services. But the owner didn't want to share equity outside of the family. The solution: a nonqualified-option plan for relatives employed by the company and a phantom-stock plan for the other executives.

If you're going to start a phantom-stock plan, you face one huge hurdle: explaining it. Marion McGovern, CEO of M 2 Inc., an $8-million broker of management consultants in San Francisco, has a phantom-stock plan--and is considering issuing phantom stock more selectively. "People didn't understand it, so why should I give it to everyone?" McGovern asks. That's a question every CEO should contemplate when considering any equity-like compensation plan. --Jill Andresky Fraser, with Susan Greco