A crucial factor in scaling a business is the ability to obtain, retain, and motivate a talented workforce. Turnover can cost employers 33% of an employee’s annual salary and others argue the number is closer to 150-250%, which is an expense that most businesses cannot afford. This is particularly true with emerging companies and innovative ventures (e.g., SBIR funded or technology based businesses), where cash flow is under-developed to accommodate the high market salary demands. For purpose-driven businesses, retaining individuals that share a company’s social purpose furthers the relationship between the company, its employees, and other stakeholders. Companies are combating employee turnover through equity incentive plans designed to align the interest of the Company and its key stakeholders and facilitate a focus on sustainability.
In this post we discuss the options (pun intended) available to obtain, retain, and incentivize key personnel through the use of equity compensation, with a focus on two forms of equity compensation in particular—stock options and restricted stock.
Generally, stock options, restricted stock, and other forms of equity compensation are offered to employees and service providers through stock plans, which are adopted and approved by the Board of Directors and shareholders.
Stock options grant the recipient the ability to purchase a specific number of shares of stock at the fair market value of the stock (the “Exercise Price”) at the time the option is granted (the “Grant Date”). Importantly, the recipient of the option does not have any rights as a shareholder until it exercises the option, which often is subject to vesting and expires on a fixed date. Vesting is a restriction on the ability to exercise, transfer, or receive the full benefit of a security (e.g., an option) until certain conditions are met, such as time (e.g., 2-years), performance goals (e.g., sales targets), or a combination of time and performance (e.g., phase II SBIR award). Ordinarily, vesting may accelerate upon certain events, such as a change of control, merger, sale, or public offering. Importantly, options may be forfeited upon a recipient terminating their employment prior to vesting (and perhaps even after vesting). An example may provide clarity:
On January 1, ABC Corp. offers Chuck, a back-end programmer, options to purchase 100,000 shares of common stock, at $0.01 per share (the “Exercise Price”), which expires on the 10-year anniversary of the Grant Date, and is subject to a 4-year vesting period with a 1-year cliff. In this example, 25% of the options vest on the 1-year anniversary of the Grant Date (the “Cliff”) with 1/48th of the options vesting each month. On the 4-year anniversary of the Grant Date, Chuck can exercise options to purchase all of the shares granted under the option by paying the Exercise Price ($1,000).
Because the Exercise Price is the fair market value of the stock on the Grant Date, options become more valuable as the value of the underlying value of the stock increases. When granted at an early stage in a Company’s development, the fair market value of the stock is likely to be low. Because the recipient gets the upside in the increase in value of the stock, he or she is incentivized to align his or her interest with the long-term success of the business. For instance, if the fair market value of the stock jumps from $0.01 to $0.10 per share, Chuck can exercise these options to capitalize on the increase in value—the difference between the Exercise Price and the fair market value at the time the option is exercised is called the “Spread.”
One important consideration for the Company and the recipient is the tax consequences. Generally, unlike restricted stock, stock options are not taxed upon grant or vesting–and whether an option is taxed when it is exercised depends on the type of option.
Incentive Stock Options or “ISOs”
Incentive Stock Options may only be granted to employees and receive favorable tax treatment if certain holding periods (and other requirements) are satisfied. If an ISO (and underlying stock) is held for more than 1-year after Exercise and 2-years after the Grant Date, then the employee will not owe federal income tax upon Exercise. By satisfying the holding requirements, the employee may receive long-term capital gain treatment on a later sale of the underlying stock. Importantly, the Company is not required to withhold employment taxes upon the exercise of an ISO. Although the exclusion from federal income tax upon Exercise is a big advantage for employees, the Spread can be subject to the Alternative Minimum Tax.
Non-Statutory Stock Options, Non-Qualified Stock Options, or “NSOs”
Non-Statutory Stock Options are stock options that do not qualify or are not designated as ISOs (such as when the ISO holding period is not met), and unlike ISOs, are not limited to employees. NSO’s that are fully vested upon exercise are taxed as ordinary income on the Spread, which is subject to withholding. This is a key difference between NSOs and ISOs. Additionally, for an NSO, the holding period for capital gain or loss begins upon exercise, and because the Spread is treated as ordinary income, the Company receives a corresponding deduction.
Restricted stock is, as its name implies, stock that is subject to restrictions (e.g., vesting). Often, the Company has the ability to repurchase the stock until it vests (and sometimes after it vests), which often depends on the recipient’s continuous employment/service. Interestingly, because the holder of the restricted stock is the beneficial owner of the stock, he or she may have voting rights and the right to receive a dividend. Similar to stock options, vesting may be accelerated upon a change of control, merger, sale, public offering, or other accelerating events.
Unless the recipient elects for tax treatment under Section 83(b) of the Code, the value of the restricted stock is not taxed on the Grant Date. Although this tax deferral may sound like a benefit, that is usually not the case, as it may be more beneficial to the employee to be taxed upon grant. For instance, if an 83(b) election is not made, the stock is taxed in the year in which it vests and the recipient must include the increase in value as ordinary income. To understand the treatment of restricted stock v. stock options, consider what would happen if Chuck had received restricted stock.
For the purposes of the example, let’s assume that on the 1-year anniversary of the Grant Date (which vested 25% of the stock or 25,000 shares), the value of the stock increased from $0.01 to $0.50 per share. If Chuck failed to file a timely 83(b) election, on the 1-year anniversary, Chuck would be taxed on the appreciation in value. However, if the Company is a private company, Chuck will not be able to freely transfer the stock so he may have a difficult time paying the tax on this phantom income. Conversely, if Chuck had filed a timely 83(b) election, then Chuck would recognize ordinary income on the date of the grant in the amount in excess of the fair market value on the Grant Date over the amount paid, if any. The ability to file a 83(b) election is an advantage to the employee when the fair market value increases substantially, which is the goal for emerging companies. When Chuck recognizes ordinary income, the Company is entitled to corresponding deduction. Note also that restricted stock is treated as wages and is subject to withholding.
When Companies offer stock compensation to their team, the outlook changes from “the Company” to “our Company.” This practice counters and alleviates the substantial risk and cost of employee turnover and aligns the long-term interest of the Company with its key stakeholders. Further, these plans have become increasingly common and investors often condition an investment on the Company maintaining an employee equity pool (e.g., 20%) prior to making an investment. Because stock incentives are “securities” and are issued as compensation they are subject to complex state and federal securities and tax laws. The failure to navigate these laws properly can have drastic and unintended consequences.
About Shayn Fernandez
Shayn is the corporate lead at Rockridge Venture Law, offering seed-to-scale-to-sale corporate counsel to entrepreneurs, emerging companies, and investors in all stages of a corporate lifecycle–from formation and fundraising to exits through M&A or IPO. Shayn’s practice areas include corporate law, finance and fundraising, securities, and mergers and acquisitions. Read more about Shayn, connect with him, and Calendly him.
Rockridge Venture Law®, was launched in 2017 to become the preeminent intellectual property and technology firm across the Appalachian Innovation Corridor. We have offices in Chattanooga, Durham, and Nashville, and represent clients and interests globally. Our services include all aspects of intellectual property, litigation, M&A, privacy, technology transactions, and ventures.
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