Commonly Considered Option Program Enhancements: Part I – Introduction and Stock Option Basics
This blog is the first post in a four-part series. Part I will provide a high-level summary of basics.
In recent years, and at least in part due to the extremely tight labor market, private companies have increasingly been faced with the question of if (and how) they should make their equity incentive programs more attractive. Equity compensation, and specifically, the of , has long been a critical component of a start-up company’s compensation package, giving employees the ability to participate in the company’s success while preserving the company’s cash for R&D and other business needs. But today offering to an employee, and perhaps particularly an executive candidate, an is likely to be met with requests for preferential terms beyond those historically seen in plain vanilla programs. In an attempt to make their more desirable, companies are invariably led to consider one or more of the following “enhancements”:
- Granting options with early exercise features;
- Granting options with extended post-termination exercise periods; and
- Implementing employee loan programs.
For sure, it may well be appropriate for a particular start-up (based on its industry, geographic location or business goals) to pull one, or several, of these levers to ensure it attracts the best and the brightest. But it is also critical that any such decisions be made with eyes wide open. In this four-part series, we discuss each of these commonly-considered program enhancements in turn, highlighting the pros and cons of each, identifying traps for the unwary, and focusing on relevant practical considerations.
In this first part, however, we focus on basics, including what are, how they serve as a valuable tool to recruit, retain and incentivize employees (and other service providers) and what their tax consequences are. Much of the information included in this Part 1 can be found elsewhere on WH Launch – we pull it all together for you here as a grounding in these concepts will be useful as we explore the topics described above in later posts.
A , whether it is early exercisable or not (more on that in our next installment), gives its holder the right to buy shares of the company’s at a fixed price, known as the exercise or , that is generally equal to the fair market value of the on the date of of the . Over time—the hope is—the value of the company’s will grow (in part by dint of the holder’s own eﬀorts) so that when the holder exercises the (that is, elects to buy the shares subject to the ), the holder can buy the appreciated company at a discount. The holder—now —can then sell the (subject to any restrictions on transfer the company may impose) and keep the proﬁts or continue to hold the and participate in any future growth as an investor in the company.
To ensure that the holder actually stays at the company long enough to participate in company value creation—and, incidentally, this is how the serves as a tool for —the right to exercise a is usually earned (or “vests”) either over time or upon the achievement of pre-established performance goals. Most commonly, an holder earns the right to exercise the with respect to 25% of the shares underlying the after one complete year of service (often called “cliff vesting”) and in equal monthly or quarterly installments for three years after that. Only once the is vested can the holder choose if and when (and the extent to which) to exercise the . If the holder leaves the company before the award is fully vested, the unvested portion of the award is forfeited. Upon exercise of the vested , the holder is issued fully vested shares of and becomes a in the company.
Other Standard Terms
In addition to generally having that are equal to fair market value on the date of and being subject to a vesting schedule, also usually have a term of 10 years (though certain granted to 10% may have a maximum term of five years). This term is shortened if the holder ceases to be employed by (or otherwise provide services to) the company. Typically, the post-termination exercise period ends three months after a cessation of service (12 months, if the holder ceases to provide services by reason of his, her or their death or disability) but the award is forfeited entirely if the holder’s service is terminated for “cause”. If the is not exercised (to the extent it is vested) by the end of the 10-year term (or the end of the applicable post-termination exercise period, if earlier), it will be forfeited.
In the United States, compensatory come in two flavors–incentive (ISOs) and nonstatutory (NSOs). ISOs may result in preferential tax treatment for the holder. However, in order to qualify as an ISO, the must satisfy specific requirements of the Internal Code. In particular:
- ISOs must be granted under an equity plan that has been approved by the company's and that has a limit on the maximum number of shares that may be issued subject to ISOs;
- ISOs may only be granted to employees ( granted to non-employee directors, consultants and advisors are necessarily NSOs);
- ISOs must have an per share that is no less than the fair market value per share of the underlying as of the date of (110% if the employee is a 10% );
- ISOs must have a term of no more than 10 years (5 years if the employee is a 10% );
- The value of the shares that become first exercisable in any year (calculated using the date fair market value) may not exceed $100,000;
- ISOs must be nontransferable; and
- ISOs must be exercised while the holder is an employee or within three months of the end of employment (or 12 months, if employment ends as a result of death or disability) to receive the beneficial tax treatment.
NSOs don't have the same restrictions. However, to avoid significant adverse tax consequences to the holder, it is generally the case (as described above) that an NSO has an per share that is at least equal to the fair market value per share of the underlying on the date of .
If the is an ISO, there is no regular federal income tax at , as the vests, or at exercise. If the holder holds the received upon exercise until a date that is more than two years from the date of and one year from the date of exercise of the , the diﬀerence between the sale price and the will be long-term (or loss). If either of those holding periods is not met, then at the time the is sold the holder will have compensation income equal to the diﬀerence between the fair market value of the at exercise and the —or the holder’s proﬁt, if less—and any proﬁt in excess of that amount will be . While the exercise of an ISO is not an income event for regular federal income tax purposes, note that the diﬀerence between the and the fair market value of the at exercise is income for alternative minimum tax (AMT) purposes and may be subject to state taxes.
If the is an NSO, there’s no tax at or as the vests. The holder will have compensation income equal to the diﬀerence between the and the fair market value of the on the date of exercise and, upon sale of the , will have (or loss) equal to the diﬀerence between the sales proceeds and the value of the on the day of exercise. This (or loss) will be long-term if it was held for more than one year and otherwise will be short-term.