Your hard-working employees bring a lot of value to your company. While you need top-quality talent to get your company up and running profitably, your bottom line may not allow you to pay top dollar for top talent. What you can do to show appreciation for your employees is to look for non-salary ways to compensate them. That’s where employee stock options come into play. We’ve created this “employee stock options for dummies” guide to help you better understand stock options and how they work. Creating a stock option program can seem complicated, especially if you don’t have a background in finance.
What Are Employee Stock Options?
In a broad sense, stock options are a valuable way that you can compensate your employees for the hard work they do to help make the company successful. Stock options are an excellent incentive that you can offer employees when you can’t offer the pay rate they expect right away. In your employee communications, it helps to periodically remind them that when the company profits, they profit as well. In that way, you’re creating a loyal partnership with your employees.
Companies can also offer shares of their stock to contractors, consultants, and investors. Stock options are contracts that give employees the right to buy or exercise shares of company stock at the grant price, which is a pre-set price. The grant price may also be called the strike price or the exercise price. Purchasing stock options is a time-limited benefit that has a deadline stated in the contract. Once the deadline has passed, the offer is closed. It’s also common for stock option contracts to state the employee’s options to exercise their stock expire once they choose to leave the company.
You have some flexibility in deciding how many stock options you can grant to your employees. You can also choose to offer additional shares for people with seniority or special skills. Bear in mind, investors and other stakeholders have to approve a company’s decision to offer stock options.
How Do Stock Options Work?
The first lesson in stock options for dummies is to understand your contract. The contract for employee stock options will list the grant date. This is the date that the stock options will begin to vest, which means this is the date that employees can sell stocks. The contract will also state how many shares the employee can sell. The stock purchasers won’t get them all at once and the stocks don’t really have any value until the stockowner exercises them.
Each contract specifies the number of shares the recipient is entitled to and how long their vesting period is. If someone gets 20,000 shares over four years, they can exercise all the shares in four years. Shares vest over time, so shareowners may be able to exercise some of the shares after a certain amount of time, according to the terms stated in their contract. One other thing to consider is called the “cliff.” The “cliff” refers to the waiting period before any of the options vests, which would be a year if the contract states it has a one-year cliff. If an employee leaves their job before the cliff period, they lose their stock options. That also gives your employees an extra incentive to remain in your employment.
Types of Employee Stock Options
The second lesson in stock options for dummies is to learn which type of stock option to offer. Companies can offer two types of stock options—nonqualified stock options (NQSOS) and incentive stock options (ISOS).
NQSOS is the most common type of stock option. Companies can offer NQSOS to employees, contractors, or consultants. The term nonqualified refers to the fact that this option doesn’t qualify for specialized tax treatment with the IRS.
Companies may only issue ISOS to employees. There is a limit of $100,000 aggregately on the value of the ISOS grant that can be vested in any calendar year. Employees also must exercise their shares within three months after they terminate their employment.
How Can Employees Exercise Stock Options?
The third lesson for stock options for dummies is to learn the three ways stock owners can exercise their stock options.
- Cash or stock: This simply means buying stock with cash, which gives the owner the maximum investment in company stock. They’ll still have to pay broker commissions, fees, and taxes.
- Cashless and sell: The owner purchases shares and sells them right away. They may even be able to use the proceeds of the sale to cover the purchase price, commissions, fees, and taxes.
- Cashless and keep stock: Owners exercise their option and sell only enough to cover the price, commissions, fees, add taxes. They keep the rest in the form of company stock.
How to Create an Employee Stock Option Plan
There are four basic steps in creating an employee stock option plan:
- Setup: Decide how to balance cash and equity compensation. Adopt your stock plan and option agreements, get approval from the stockholders and your board, and secure all relevant state permits.
- Maintenance: Establish a way to keep your valuations up to date. Determine how many stock options will be needed for new hires and create a stock option pool. Monitor your pool considering future hires.
- Making Offers: Confirm that you have enough allocated shares to offer new employees to prevent legal problems later. Confirm that the employee is legally available for work. Any new employees that have more than 10% equity must have a strike price that is 110% of the 409A share price valuation. Offer the grant in terms of shares stating that it’s subject to board approval.
- Finalizing Grants: Have the 409A re-valuated if required by the rules. Have the board approve the employee’s stock option grant, noting any standard deviations. Process and execute the agreement and update the company cap table.
What Are the Tax Implications of Exercising Stock Options?
Your employees and other stockowners should also be made aware of the tax implications of exercising their stock options.
With NQSOS, stockowners only pay taxes when they exercise their stock options. Your company withholds taxes such as Social Security, Medicare, and income tax when the owners exercise NQSOS. When stockowners sell their shares, they get taxed under the rules for capital gains and losses.
With ISOS, the shares qualify for special tax treatment and these shares aren’t subject to Social Security, Medicare, or withholding taxes. If stockowners hold their ISOS shares for more than two years from the grant date and more than a year from the exercise date, they get the benefit of favorable long-term capital gains tax on all appreciation over the exercise price. The thing to be cautious about is that the paper gains on ISOS shares that are held past the calendar year of exercise can subject them to the alternative minimum tax. If the company stock price drops suddenly, stockowners could be paying a large amount of tax on declining income.
We believe that maintaining your cap tables should be easy and not time-consuming. We want you to be able to determine at a glance what you can offer your employees, consultants, investors, and contractors because you have the assurance of knowing that your data is accurate and current at all times.