Aspects to be Considered While Setting Up an Employee Stock Options Process (8 min)
The offering of stocks to employees is an extremely effective method of attracting, retaining, and motivating the employees, more so when a company is not able to offer high pay package. A Stock Option Plan gives the company a flexibility to award stocks to its employees which includes the directors, advisors, officers and consultants, allowing all these people to purchase stocks of the company when they exercise the option.
The Stock Options give the employees an opportunity to get their share in a company’s success without requiring the startup business to spend cash. The Stock Option Plans actually contribute to the capital of a company as the employees pay the exercise price for the options.
Hundreds of people have become millionaires because of the stock options, which makes these options more appealing to the employees. For example, Facebook has helped many employees to become millionaires through the stock options. The huge success of the Silicon Valley companies and their employees who held stock options have made the Stock Option Plans a very powerful motivational tool for the employees to work towards a company’s long term success.
Why the companies issue stock options to the employees
The companies issue stock options for one or more of the below mentioned reasons:
- Stocks can be used to attract and retain the talented employees.
- Stocks can help the smaller companies compete with bigger companies in attracting the best employees.
- Stocks can help motivate the employees and make them more dedicated and committed.
- Stocks can be a very cost effective employee benefit plan replacing additional cash compensation or the bonus amount spent on the employees
Few key aspects to be considered while offering stock options
A company has to address a few key issues before adopting a Stock Option Plan and issuing the options. Usually, a company adopts a plan which gives it the maximum flexibility. Below mentioned are some of the important factors which need to be considered:
- Number of the shares: The stock option plan must have maximum number of shares which can be issued under the plan. This total number is usually based on what the directors believe is appropriate, but normally ranges from 10% to 15% of the company’s outstanding stock, depending on the the company’s growth.
- Number of the options to be granted to an employee:There is no fixed formula as to how many options a company can or will grant to a specific employee. It’s all negotiable, however the company can set some internal guidelines as per the job position within the company.
- Consideration: The plan should give the board maximum flexibility in determining how the exercise price can be paid, subject to the compliance with applicable corporate law. For example, the consideration can include cash, promissory note, deferred payment or stock. A “cashless” feature can also be very attractive, where the optionee can use the buildup in the value of the option (the difference between the exercise price and the stock’s fair market value) as the currency to exercise the option.
- Shareholder’s approval: The company should normally have the shareholders approve the plan, both fromthe securities law perspective and to cement the ability to offer tax advantaged incentive stock options.
- Administration:Most plans appoint the board of directors as the administrators and the plan must also allow the board of directors to delegate the responsibilities to a committee. The board or the committee must have broad discretion as to whom the options can be issued, the types of options granted and the other terms.
- Right to terminate employment: In order to prevent the employees from an implied promise of employment, the plan must clearly state that the grant of stock options does not guarantee an employee a continued relationship with the organization.
- Right of first refusal: The plan must also provide that when an option is exercised, the shareholder grants the company a right of first refusal on the transfers of the underlying shares. This will allow the company to keep the share ownership in the company to a limited group of shareholders only.
- Vesting: Most of the companies provide a vesting schedule, where the employee or the advisor has to continue to work for the company for a minimum period of time before the optionee’s rights vest. For example, an employee may be awarded options to acquire 10,000 shares with 25% vested after the first full year of employment, and then monthly vesting for the remaining shares over a 36-month vesting period.
- Financial reports: From the securities law perspective, the plan would require periodic financialreports and information to be delivered to the holders of the option.
- Exercise price: Exercise price is the amount the optionee has to pay for the stock when he or she exercises their options? Usually, the price is set at the stock’s fair market value when the option is granted. Then if the stock’s value goes upward, then the option becomes more valuable because the optionee has the right to buy the stock at the cheaper price.
- Exercise period: This is the time period for which the optionee has the right to exercise the option. The Stock Option Agreement usuallyfix a date when the option must be exercised (the date is shortened in case of termination of employment or death). Mostly employees have 30 to 90 days to exercise an option after their employment with the company has been terminated.
- Transferability issues: These issues are the restrictions which apply to the transfer of the option and the underlying stock.For most of the Stock Option Agreements the option is nontransferable. The agreements further state that the stock purchased by exercising the option might be subject to rights of purchase or rights of first refusal on any transfers.
- Compliance of Securities law: The issuance of options and underlying shares should be in compliance with the federal and state securities laws. Experienced corporate counsel must be involved here.
- Cash needed: In order to exercise an option, the holder typically has to pay cash out of the pocket for the exercise (unless there is a provision where company allows “cashless exercise”).
- ISOs:An employee holding Incentive Stock Options (ISOs) does not have a tax (or tax withholding) event upon exercise. The employee will report taxable income only when they sell the stock. If certain holding periods are met before the time of selling the stock, then all of the gain (back to the exercise price) might be taxed at the more favorable long term capital gain rates.
- NSOs: If the options are not tax advantaged ISOs, they are called “non qualified stock options” (NSOs), and the spread upon exercise will be taxed at the more unfavorable ordinary income rates and not at the capital gains rates.
- Illiquidity: Stock options in privately held companies is usually not liquid and is quite difficult to sell.
While offering the stock options you need to consider all the above factors very objectively and come up with an equity package which is the best for your company and the employees as well. Being a founder, you should treat your employees like the true owners of the company. The standard equity packages are changing quite rapidly now and you need to be a part of this new wave of treating the employees as the true owner which would help the business immensely in the long run.
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