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:
2. Equity Plans – Stock Options and Restricted Stock
3. Stock Option Plans ◄You are here
4. Restricted Stock Plans
5. Company Buy-Back and Repurchase of Stock Options and Restricted Stock
6. Cash Plans, Phantom Stock Plans and Stock Appreciation Rights
7. Summary and Plan of Action
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.
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.
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.
You should hire an 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, Business Lawyer. From there you can link to other pages and articles of interest.