Overview

Companies often utilize stock options as a way to compensate advisors and consultants, and as a way to not only compensate their employees but to energize and motivate them to improve and grow the business.[1] In granting employees options to purchase shares (equity) of the company, it is intended to align their interests with the company and engender loyalty since as the shares underlying the options grow in value, so does that of the business and the employees stake in it (which may outpace a cash salary).[2] In addition, a company can conserve valuable working capital by compensating employees, executive officers, directors, advisors and consultants with stock options instead of cash.[3] Truly, in regards to employees, stock option grants are a powerful tool that can benefit both the company and employees in tandem.

Still, equity based compensation programs introduce significant complexities when it comes to taxes, accounting and legal matters. In addition, because of their potential dilutive effect, the existence of a large amount of outstanding options could have a chilling effect when seeking investors such as venture capital and private equity firms to invest in the company. The overuse of options grants (in order to conserve cash) may deter investors from infusing necessary capital into the company as it moves through its life cycle.

Stock Options

In general, a stock option gives the holder the right, but not the obligation, to purchase a company's shares at a specified price: the “exercise” or “strike” price. In the vast majority of cases, options are granted at “fair market value”[4] which means that the exercise price matches the price (value) of the underlying shares at the time of the grant (“FMV”).[5] There are essentially two types of stock options typically used: incentive stock options (“ISOs”) and non-qualified stock options (“NSOs”).

Both ISOs and NSOs give the option holder a right to purchase shares of stock at a stated exercise price. The option creates value when the shares underlying it is greater than the exercise price. It is common for a stock option plan to permit both types of grants — but there are important differences between them. As such, it is vital for companies to understand their differences.

Primary Differences Between ISOs and NSOs

ISOs

As noted below, there are many criteria an option must meet in order to qualify as an ISO. Most importantly, ISOs can only be granted to employees. Further, among its attributes, for an ISO option holder there is no taxable event for the option on (i) the date of grant or (ii) on the date or dates of vesting.[6]

In order to qualify as an ISO the option:

• must be granted to employees only (grants to non-employee directors or consultants, for example, will be deemed NSOs);
• must be granted in accordance with a written plan that (i) is approved by a formal vote of shareholders within 12 months before or after the plan’s effective date, and (ii) includes the aggregate number of shares available to be granted, as well as the employees or class of employees eligible to receive options;
• must be granted within 10 years from the date the plan is adopted or the date the plan is approved by shareholders, whichever is earlier;
• cannot have a term that exceeds 10 years from the date of grant;
• must not be less than the FMV of the stock on the date of grant;
• if granted to a shareholder who owns 10 percent or more of the total combined voting stock of the company (or its parent or subsidiary), must specify an exercise price of at least 110 percent of the FMV on the date of grant, and the term of the option must not exceed five years;
• must not be transferable except upon death; and
• must be exercised while the employee is still employed or within three months of termination of employment (12 months if the termination is the result of death or disability).[7]

On the date the option is exercised the “value spread” (the difference between exercise price and FMV at the time of exercise) is taxable for alternative minimum tax (“AMT”) purposes. At the date of sale (or other disposition) of the underlying stock, either of the following will occur:

• If the sale occurs both (a) more than two years after the option grant date and (b) more than one year after the date of exercise (the “ISO Holding Periods”), then the option holder is taxed at long-term capital gain rates on the difference between the sale proceeds and the purchase price (exercise price) paid (plus any amounts taxed as ordinary income for Alternative Minimum Tax); or
• If the individual does not meet the two ISO Holding Periods, then the excess, if any, of the lesser of (a) the FMV of stock on date of exercise or (b) the proceeds from the sale, in each case, over the purchase price will be taxed as ordinary income.[8]

From the company’s perspective, however, NSOs are advantageous because the company can take tax deductions when the employee or consultant exercises the stock option because with an NSO the stock option is considered ordinary income to the employee or consultant. With an ISO, there is no tax deduction for the company.[9]

NSOs

Similar to ISOs, neither the granting of an NSO, nor any vesting date relating to it, is a taxable event. However, both the (i) exercise of the NSO and (ii) sale of the underlying shares are taxable. Upon exercise, the holder of the NSO will be taxed on the value spread. The NSO holder will then again be taxed upon the sale of the share into which the NSO was converted. Further, the granting of an NSO is not limited to just employees and NSOs are not limited to a 10 year term. Other characteristics of an NSO include:

• No income is reportable or includible at the time of grant;
• The value spread at the time of exercise is treated as wages for income tax and (payroll) tax reporting and withholding purposes with respect to an exercising employee. Wage withholding and reporting do not apply to exercises of non-employee (I .e., non- employee director or consultant) NSOs;[10]
• The company receives an income tax deduction for the amount of wages recognized by an employee (or income recognized by a non-employee) with respect to the NSO exercise;
• The tax basis of the stock received upon exercise is equal to the FMV of the stock on the date of exercise. Effectively, the employee or non-employee receives basis for the exercise price paid plus the amount of ordinary income recognized upon exercise;
• The Holding Period for the stock begins on the date of option exercise; and
• A subsequent sale of the underlying stock should be eligible for long-term capital gain or loss treatment as long as the stock is held for more than one year from the date of exercise.

Dispensing Options in Practice

As a company begins down the road of utilizing options as a compensation method for employees (and others), it should – at the outset – prepare itself for relationships that will last for years and certain legal responsibilities it must meet in order to provide for them. In addition, the company must prepare to properly maintain and operate the apparatus (plan) which will be dispensing options and keeping track of them as vesting, exercises and sales occur.[11]

Therefore, a company should prepare and formerly adopt a stock option plan (or plans) that can act as a “depository” (reserve of shares) and guide for the options the company may wish to grant. In this regard, a company should:

• Reserve (allot) a certain portion of available and yet unissued shares for the purposes of stock option exercise and subsequent issuance of shares underlying such options;
• Prepare and adopt a broad compensatory equity (stock option) plan[12] appropriate for the granting of options as management and the board of directors envisions;[13]
• Propose such plan to the shareholders and attain their approval of it;
• Develop a plan for administering the issuance of the options and the underlying shares relating to the stock option plan, as well as maintaining controls and procedures for its books and records; and
• Prepare a document providing the necessary disclosures to be provided to the recipients at the appropriate time (as discussed in further detail below).

Disclosure Requirements

Before issuing the shares underlying any options, a company must satisfy certain minimum disclosure requirements. Namely, the company must provide a copy of the relevant stock option plan to all eligible recipients at a reasonable time prior to the “sale” of of the underlying shares relating to the grant (for stock options, then prior to the date of exercise). Best practices would dictate that a copy of the plan be provided to the recipient at the time of the option grant.

However, if the aggregate sales price of securities (e.g.,shares underlying the options) sold by the company exceeds $10 million in a 12-month period[14] then, in addition to providing recipients with a copy of the compensatory plan, the company must also provide additional disclosures to all eligible recipients (e.g., a summary of the material terms of the compensatory plan; risk factors; financial statements of the company prepared in accordance with U.S. generally accepted accounting principles (GAAP) dated not more than 180 days before the sale: and other enhanced financial information). Indeed, the company may wish to prepare and have ready a document containing all of the required disclosure and information if it envisions or foresees crossing the $10 million threshold. Further, a company must keep in mind that any such disclosures provided are subject to the anti-fraud provisions under the Federal securities laws.

M&A Transactions and Treatment of ISOs

In many transactions, the buyer and the target (the “Target”) will agree that the Target's obligations under its stock option plans will be assumed by the buyer. Often, substitute options to purchase buyer's stock will be “swapped” for the outstanding options to purchase the Target stock. Generally, the buyer will be able to make this substitution so that the employee/option holders are not taxable on this substitution itself. In such a substitution, the Target's option holders will generally be able to preserve the gain inherent in their old Target options, while maintaining a continuing stake in the appreciation of the ongoing (post-acquisition) business.

Assuming or Substituting ISOs

Where the Target has outstanding ISOs, one concern will be preserving the qualified ISO status of those options to the extent possible. Some option plans, not carefully drafted, contain provisions that would disqualify the ISO treatment of the option holder upon a sale of the company. For example, the Target's option plan may provide that ISOs vest automatically on a change in control. This has the potential to cause a large number of options to lose ISO status because of the annual dollar limit ($100,000).[15]

It is also important to insure that the assumption does not result in a "modification" of the ISOs. Modification refers to another potentially negative consequences. A modification may occur if the option terms change, giving the employee additional benefits. This determination as to whether an ISO is modified can result in it being “reissued.” as of the date of the modification. This re-issuance treatment means the option will be retested as of that moment for purposes of whether is meets the ISO requirements (for example, the determination of FMV, which at the time of the merger or acquisition may be much greater than the original exercise price thus precluding ISO treatment). Furthermore, should the modification involve the “re-pricing” or extending the term of an “in-the-money” option then a Section 409A analysis and valuation may be required.[16]

Investor Assessment

When a company is seeking to attract capital infusions from venture capital and private equity firms, or other similarly active investors, maintaining the proper controls and procedures in the administration of the company’s compensatory equity plans will allow for such investors to perform and easily assess the potential dilutive effect of any outstanding options on any proposed investment they may be contemplating.

Conclusion

The ability of a company to issue options to employees, advisors and consultants is a valuable tool in attracting and retaining talented employees, engendering their loyalty, as well as a valuable currency when retaining advisors and consultants. While it is a complex and always evolving tool, when utilized skillfully, the use of stock options can be a great part of the tapestry of a growing and maturing company.

This memorandum is a summary of the topics discussed above and does not purport to provide legal advice. No legal or business action should be based upon the above summary.