Stock Option Plan Basics

Stock Option Plans or Stock Incentive Plans are commonly used in start-ups, as these entities have limited cash flow initially.  Employees who go to work for these entities usually seek higher reward for their risk. Issuing stock options instead of, or in addition to, cash payments of salaries helps the interests of both employee and employer.  If you are considering adopting aStock Option Plan, the following rudimentary information should be helpful to help understand some of the basics of the plan and its administration.

What is a Stock Option? A Stock Option is the right to purchase shares of the company’s stock in the future, at a price that is fixed today. This price is referred to as the “Exercise Price” or “Grant Price.” Generally, the right lasts for a set period of time, the “Term”, usually 3 or 5 years. This means if the option is not exercised by the end of the 3rd or 5th year, the right to purchase the stock at that set price expires.

For example:  ABC Company grants it’s CEO an option to purchase 100 shares of ABC Company common stock with an exercise price of $2.00 for 3 years.  The CEO has the ability to purchase up to 100 shares of ABC Stock at $2.00 per share. This will be beneficial to the CEO if in three years, the stock price of ABC Company common stock is trading, or has a value of $3.00 a share. He has the ability to purchase the stock at a discounted price.

The Company may also place restrictions on when the options are earned. This can be accomplished by creating a vesting schedule. An option “vests” when the right to purchase the shares is earned or realized, and the right to purchase is available to the employee.

For example: ABC Company grants its CEO an option to purchase 100 shares of ABC Company common stock with an exercise price of $2.00 for three years. After one year, the option to purchase 50 shares vests. Then, 25 vest after the second year and the remaining 25 at the end of the third year.  This means that the CEO cannot exercise his option, or purchase any of the shares until one year after grant- and then he can only purchase 50.  After the second year he can purchase up to 75, and he cannot purchase the full 100 until the third year.

Companies use this vesting schedule ensure the Employee remains working for the employer for the entire term of the option and stays committed to his or her work.

There are generally two types of options 1) Incentive Stock Options (“ISO”) and 2) Non-Qualified Stock Options (“NQO”).

  • Incentive Stock Options- ISOs are only granted to employees of the company. As long as the Stock Option Plan as a whole is adopted and approved by the Shareholders of the company, then the ISOs qualify for a more favorable tax treatment. Basically, the gain recognized by the employee’s purchase of the shares is not a taxable event until the employee sells the shares. This is advantageous as the employee will theoretically have an easier time paying the taxes upon a sale of the stock and receipt of the funds.
  • Non-Qualified Options- NQOs are options that do not qualify for the special tax treatment, but instead the taxable event is at the time of exercise. The taxable amount is the difference between the exercise price ($2.00) and the market value on the date of exercise ($3.00). NQOs however can be issued to employees, directors and outside consultants.

If you are considering adopting a Stock Option Plan, contact your corporate or general counsel as there are many other implications and complex issues not raised in this post.

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