Employee Stock Option Basics for Growing Companies
Stock options are a common compensation strategy used by start-up and growth-stage companies to attract, motivate, and retain employees, particularly when competing for talent against larger, more established companies. Offering options to potential employees may allow these companies to pay lower base salaries and conserve current cash flow, while providing significant potential upside incentive to employees.
This article provides a summary of how a typical option works and some of the considerations for founders and business owners contemplating offering stock options as part of their compensation package.
In basic terms, a stock option is a contract between a Company and the employee in which the Company agrees to sell stock to the employee in the future at the price fixed in the option contract (the “Strike Price”) as of the contract date (the “Grant Date”). For tax reasons, the Strike Price is often the fair value of share of stock on the Grant Date, as valued by the Board of Directors. Two important time-based attributes of a stock option are the “term” and “vesting period.” The term is the length of time over which an option is outstanding and in which time period an employee has to exercise the option. Typically, a stock option term is ten years. The vesting period defines the time over which an employee earns the right to purchase the underlying stock under option within the term. For example, a stock option may vest ratably over 3-to-4 years, meaning the employee effectively earns the right to exercise the option over a 3-to-4 year time period and has within a ten year term, starting at the Grant Date, to execute the exercise of an earned option. This structure is designed to provide a retention incentive for the employee as the Company grows. Stock options have value to the employee if the price of the stock increases after the option is granted. For example, a Company grants 1,000 shares under a stock option to an employee providing to the employee the right to buy 1,000 shares at $1 per share and in five years, the Company’s stock is worth $50 per share, the employee could exercise their shares under option and purchase 1,000 shares for $1,000. Presuming the Company’s stock was publicly traded at the point of option exercise, the employee could then sell the shares for $50,000 and realize a $49,000 gain.
While options are a way for growing companies to conserve cash and align employee and owner interests, there are several complexities to be considered when contemplating an option plan, such as:
- The “opportunity cost” of the options in terms of dilution to current ownership interests and future capital foregone by the Company.
- The plans must be carefully strutured and the underlying stock properly valued to avoid unanticipated tax consequences and to achieve desired outcomes (such as capital gain treatment for option holders). There are several tax implications to consider. For example, certain types of options generate taxable compensation income upon exercise regardless of whether the shares received are sold.
- The current and future financial reporting impacts, as GAAP requires fair-value based measurement and financial statement recognition of equity compensation arrangements. Additionally, certain types of arrangements and modifications thereto could have unanticipated financial statement impacts.
- The cost of implementing a plan, both in terms of professional fees for establishing the plan and the cost of ongoing administration.
Navigating these complexities successfully requires that a Company’s equity component of its compensation plan is prepared in conjunction with legal counsel, HR leadership, and a CFO or accounting advisor.
If you are in need of assistance or guidance as it relates to the finance, tax, or HR impacts of your Company’s current, under-review, or yet-to-be formulated compensation plan and its component parts, The Fahrenheit Group has subject matter experts and project, fractional, or interim advisors that can help you address and simplify the plan’s complexities.
If you would like to find out more about how The Fahrenheit Group can assist you achieve your professional and business goals, please contact me at firstname.lastname@example.org.
Vincent T. “Vince” Morgus has 20+ years of Corporate Finance and Corporate Development experience and serves as the Managing Partner of Fahrenheit’s Carolinas practice. Vince has held roles in the United States and abroad, with demonstrated accomplishments in financial planning, forecasting and analysis, strategy development, management and execution, capital markets transactions and alliances, partnerships, and mergers and acquisitions. “The Carolinas” practice extends Fahrenheit’s work with emerging-growth and small-to-middle market companies into the Southeast.
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