How Worker Inventory Choices Work in Startup Firms

By Nancy Carrillo Last updated Nov 12, 2020

Revised and updated on November 11, 2020

Stock option plans are an extremely popular way to attract, motivate, and retain employees, especially when a company is unable to pay high salaries. A stock option plan gives a company the flexibility to grant stock options to employees, officers, directors, advisors, and advisors so that if they exercise the option, they can buy stock in the company.

Stock option plans allow employees to share in the success of a company without a startup company having to spend valuable money. In fact, stock option plans can actually bring capital to a company because employees pay the exercise price for their options.

The main disadvantage of stock option plans is the potential dilution of other shareholders’ equity when employees exercise their stock options. For employees, the main disadvantage of stock options in a private company compared to cash bonuses or higher compensation is the lack of liquidity. Unless a company creates, is acquired, or offers to buy the employees’ options or shares, the options are not cash benefits. And unless the company gets bigger and its stocks don’t get more valuable, the options can ultimately prove worthless.

Thousands of people have become millionaires through stock options, which makes these options very attractive to employees. (In fact, Facebook turned many employees into millionaires from stock options.) The spectacular success of Silicon Valley companies and the resulting economic wealth of employees who owned stock options have made stock option plans a powerful motivational tool for employees to long for a company to work -term success.

How does a stock option work?

The following shows how stock options are granted and exercised:

ABC Inc. hires John Smith.
As part of its employment package, ABC grants John options to purchase 40,000 common shares of ABC at 25 cents per share (the fair value of one ABC common share at the time of grant).
The options are subject to a four year vesting period with a one year vesting period, which means that John must stay with ABC for one year before being given the right to exercise 10,000 of the options and then exercise the remaining 30,000 options at a rate of 1/36 per month for the next 36 months of employment.
If John leaves ABC or is fired before the end of his first year, he will not be given either option.
After his options are “vested” (exercisable), he has the option to buy the stock at 25 cents per share, even if the stock’s value has risen dramatically.
After four years, all 40,000 of his option shares will vest if he continues to work for ABC.
ABC becomes successful and goes public; The stock trades at $ 20 per share.
John exercises his options and buys 40,000 shares for $ 10,000 (40,000 x 25 cents).
John turns around and sells all 40,000 shares for $ 800,000 (40,000 times the publicly traded price of $ 20 per share), making a nice profit of $ 790,000.

Why do companies issue stock options?

Companies typically issue options for one or more of the following reasons:

Options can be used to attract and retain talented employees.
Options can help motivate employees and make them more engaged.
Options can be a low-cost employee benefit plan instead of an additional cash payment or bonus.
Options can help smaller companies compete with larger companies to attract great employees.

Main problems with stock options

A company must address a number of key issues before it enters into a stock option plan and before issuing options. In general, a company wants to adopt a plan that gives it maximum flexibility. Here are some important considerations:

Total number of shares. The stock option plan must reserve a maximum number of shares to be issued under the plan. This total number is generally based on what the Board of Directors deems appropriate but is typically between 10% and 15% of the company’s outstanding shares depending on the company’s growth phase. Of course, not all options reserved for emissions need to be granted. Venture capital investors in the company may also have contractual restrictions on the size of the option pool to prevent over-dilution.
Number of options granted to an employee. There is no formula for how many options a company will give a potential employee. It’s all negotiable, although the company can set internal guidelines based on position within the company. What is important is not the number of options, but the percentage of the fully diluted number of shares issued. For example, if you are given 100,000 options but there are 100 million shares outstanding, that’s only about 1/10 of 1% of the company. However, if you are given 100,000 options and only 900,000 shares are outstanding, that equates to 10% of the company.
Plan administration. While most plans appoint the board of directors as administrator, the plan should also allow the board to delegate responsibilities to a committee. The Board of Directors or the committee should have a wide discretion as to the recipients of the options, the types of options granted and other conditions.
Recital. The plan should allow the Board of Directors maximum flexibility in determining how the exercise price may be paid, provided that applicable company law is complied with. For example, the consideration can include cash, deferred payment, promissory note, or shares. A “cashless” function can be particularly attractive if the option recipient can use the increase in value of their option (the difference between the exercise price and the fair value of the share) as the currency for exercising the option.
Shareholder approval. The company should generally have its shareholders approved by shareholders, both for securities law reasons and to consolidate the ability to offer tax-privileged stock options with incentives.
Right to terminate the employment relationship. In order to prevent employees from receiving an implicit employment promise, it should be clearly stated in the plan that the granting of stock options does not guarantee any employee a lasting relationship with the company.
Right of first refusal. The plan (and the associated stock option agreement) may also provide that the shareholder grants the company a right of first refusal on the transfer of the underlying shares if the option is exercised. In this way, the company can keep the stake in the company to a limited group of shareholders.
Financial report. For securities law reasons, the plan may require that option holders be provided with financial information and reports on a regular basis.
Vesting. How are options transferred? Most companies offer a vesting schedule that requires the employee or consultant to continue working for the company for some time before the option recipient’s rights vest. For example, an employee can be granted options to acquire 10,000 shares with 25% freedom of movement after the first full year of employment and a subsequent monthly blocking period for the remaining shares over a blocking period of 36 months.
Exercise price. How much does the option recipient have to pay for the stock if they exercise their options? As a rule, the price is set at the time the option is granted based on the fair value of the share. If the value of the stock rises, the option becomes valuable because the option taker has the right to buy the stock at a cheaper price.
409A rating. The company must determine the fair value of its common stock in order to determine the exercise price of the option under Section 409A of the Internal Revenue Code. This is often done by hiring an outside valuation expert.
Exercise period. How long does the option holder have the right to exercise the option? The stock option agreement usually specifies a date on which the option must be exercised (the date is usually shortened on termination of employment or death). Most employees only have 30 to 90 days to exercise an option after their employment with the company is terminated. This can be onerous, especially as the option recipient may not have been able to sell any of the underlying stocks to pay the tax resulting from exercising the option.
Portability problems. What restrictions apply to the transfer of the option and the underlying shares? Most stock option agreements state that the option is non-transferable. The agreements also stipulate that the shares acquired by exercising the option may be subject to purchase or pre-emptive rights in the event of potential transfers.
Compliance with the Securities Act. The issue of options and underlying shares requires compliance with federal and state securities laws. An experienced management consultant should be called in here.
Cash is usually required. In order to exercise an option, the option holder must typically pay out of pocket cash to exercise (unless the company allows “cashless exercise”).
ISOs. An employee holding tax-privileged Incentive Stock Options (ISOs) will not have a tax event (or tax retention event) when exercised. The employee will report taxable income when selling the stock, but must account for the difference in income between the exercise price and the current market value at the time of exercise (the “Spread”) to calculate additional tax liability under the alternative minimum tax rules. If certain holding periods are met prior to the sale of the stock, the entire profit (back at the exercise price) can be taxed at the more favorable long-term capital gains rates.
NSOs. If the options are not tax-privileged ISOs, they are “non-qualifying stock options” (NSOs) and the spread upon exercise is taxed at the less favorable ordinary income rates (as opposed to capital gains rates). Because the exercise date is a chargeable event, the company must report the spread in the year of exercise as taxable income on the employee’s Form W-2 and withhold applicable taxes on the amount of the spread, which generally means that The employee must write a check to the company to cover the tax deduction requirement.
Illiquidity. Privately held company shares are typically illiquid and difficult to sell.

Read everything from Richard Harroch’s article on AllBusiness.com.

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