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Stock Option Plans, Restricted Stock, Phantom Stock and
Other Incentive Plans
for Closely Held Businesses
Article #3 – Stock Option Plans
This series of
articles explains how restricted stock, stock options, cash
plans and phantom stock really work for closely held
companies, and what their real value is for the company and
the employee.
The articles in
the series are:
In this article
#3, I explain how you use stock option plans to reward and
encourage employees. In the prior article,
Equity Plans – Stock Options and Restricted Stock I
introduced ten basic concepts for all equity plans, whether
stock option plans or restricted stock plans. You should
understand the prior article before moving on to this
article.
Stock Option Plans Work Well for a Large Amount of Employees
The key concept to
remember about stock options (as opposed to restricted
stock) is that they work best when you want to bring a
larger number of employees onto the team. You’re giving
equity in small pieces to a number of employees.
Stock option plans
involve a lot of paper and administration. They also
require a filing with the State of California and the
payment of a filing fee. For these reasons, stock option
plans cost a few thousand dollars to implement. You need a
large number of option grants to justify this expense.
Vesting
The options vest
over a term of years. A common structure is to have the
options vest over 4-5 years with a 1 year "cliff" and
monthly vesting thereafter. Let’s assume you use a 5 year
vesting schedule (4 or 5 years is standard). This means
that the employee will not receive any options until the end
of the first year (the cliff year). At the end of the cliff
year, the employee will receive 1/5th of the
total amount of options. After that, the employee will
receive, every month, 1/60th of the total amount
of options. At the end of 5 years, the employee will have
vested in all the options that you granted to him.
Exercise Price
All options have
an exercise price. The exercise price for options is the
fair market value of the underlying common stock on the date
of grant of the options. Your board of directors determines
fair market value in its reasonable discretion. Hence if on
the date of grant of the options your common stock is worth
$1 a share, then the exercise price will be $1 a share.
ISOs and NSOs
Options come in
two flavors: incentive stock options (ISOs) and nonqualified
stock options (NSOs). In brief, you usually give ISOs to
your employees and NSOs to your consultants. ISOs are
tax-beneficial to the employee because they convert ordinary
income into long-term capital gains. NSOs are
tax-beneficial to the company because it usually can take a
deduction for the compensation deemed paid upon exercise of
an NSO. I will not go into further detail because the tax
laws for ISO and NSOs are too complex for this introductory
article. You can find countless articles on the internet
about them, however.
Repurchase of
Stock
Get your stock
back when the bum quits. For all vested options and
purchased stock, you will want the ability to take the stock
back from the employee when you fire him or he quits. I
discuss this at length in
Article 5 -
Company Buy-Back and Repurchase of Stock Options and
Restricted Stock.
Summary of Stock Option Plans
With a stock
option plan, you give a number of employees equity in
installments over a number of years. The employees pay to
exercise the options. Once the options vest and the
employees exercise them, they get real stock. At that point
they are real shareholders.
Shameless Plug
You should hire a securities
attorney to help you with your stock option plan.
It’s
expensive to have me fix a bad plan; it’s cheaper to do it
right the first time.
If you want to read more try my
main page,
Securities Attorney. From there you can link to other
pages and articles of interest.
Call me to schedule a legal consultation:
510-796-9144 | 