One of the biggest challenges facing early-stage companies is attracting and retaining talent. Companies at the beginning of their life-cycle usually don’t have endless sources of cash to provide compelling compensation packages to their employees. In fact, the founders themselves often have to wait years before their companies can afford to pay them market-level compensation. But without the right people in place to operate the company and help it to grow, it is unlikely that things will ever truly get off the ground. Granting stock options to employees as a component of their overall compensation can help bridge that gap in a way that can prove economically and tax effective for both the employer and the employee.
Retention and Alignment
Aside from taking pressure off of the company’s cash balance position, stock options serve two other important functions as an element of compensation. Subjecting a stock option to a time-based vesting schedule creates a very powerful incentive for employees to remain employed with the company so that they are not walking away from the potential value represented by the stock option. In that regard, stock options can be used as an employee retention tool. And creating a class of employees who are ultimately going to be shareholders gives those employees additional motivation to work toward increasing the value of their employer, focusing on both current company performance metrics while also keeping a forward-thinking eye on company growth. This alignment between employees and shareholders ensures that everyone is rowing in the same direction.
Mechanics of Stock Options and Key Terms
Before wading through the economics and tax consequences of stock options, it is important to establish a baseline understanding of what a stock option is and how it works. A stock option is effectively a contract that grants the holder the right, but not the obligation, to buy shares of stock at a fixed price on or before a certain date. The terms and conditions of the stock option are usually specified in a written stock option award agreement, which may contain all of the relevant provisions or may be subject to the terms and conditions of a governing stock option or omnibus equity incentive plan.
Certain fundamental issues must be addressed in the award agreement. First, the stock option will be granted on a “grant date” and will contain an “expiration date” on or before which the stock option must be exercised. Typically, in the US, stock options expire on the tenth anniversary of the grant date. Upon “exercise” of a stock option, the holder pays the “strike price” per share (fixed at the time of grant) times the number of shares for which he/she is exercising (equal to the “aggregate exercise price”), in exchange for the specified number of shares subject to that stock option.
Employee stock options are rarely exercisable at grant; they are usually subject to specified vesting conditions relating to continued employment through a certain date or dates (“time-based vesting”), the company’s performance (“performance-based vesting”), or a combination of both. Upon receipt of shares in connection with the exercise of a vested stock option, the employee may be free to sell those shares immediately or he or she may be subject to additional restrictions set forth in a shareholders agreement or other similar agreement. He or she may, nonetheless, elect to hold those shares for some period of time in the hopes that the market value of those shares will increase over time.
Economics of Stock Options
Stock options are typically exercised at a time when the specified strike price is less than the fair market value of the shares, which means the employee is acquiring those shares at a discount. So, the actual value realized upon exercise of a stock option is the difference between the fair market value of shares at the time of exercise and the strike price paid for shares (known as the “spread”). It is important to keep in mind that a stock option is not truly a “full value” award but, rather, an “appreciation award”; the holder of a stock option will only realize the increase in value of the shares from and after the date of grant. This appreciation in value is the compensation realized by an employee upon exercise of a stock option.
While many companies require the employee to pay the aggregate exercise price in cash upon exercise, some employers allow employees to “net settle” their stock options, withholding a number of shares with a fair market value equal to the aggregate exercise price to satisfy payment of the aggregate exercise price. The end result is the same; the employee ends up with an amount of compensation equal to the spread at the time of exercise. It follows, then, that an employee will only exercise a stock option if the current fair market value of a share is greater than the strike price (i.e., there is a positive spread at the time of exercise).
Taxation of Stock Options
One of the most attractive features of stock options for both employers and employees is the taxation thereof. Because they generally do not have a readily ascertainable value upon grant, stock options are usually not subject to income tax upon grant or even vesting thereof. An employee is taxed on the spread upon the actual exercise of the stock option. As with cash compensation paid to employees, employers must deduct and withhold income and FICA taxes from the compensatory element of the stock option at the time it is deemed paid (i.e., upon exercise, or, if later, upon the vesting of the underlying stock if unvested upon exercise). In contrast to the concept of “net settlement” of a stock option with respect to the exercise price, companies rarely allow employees to receive fewer shares in order to satisfy these tax withholding requirements. Typically, as a condition to exercise, a cash payment must be made to the employer by the employee to satisfy the withholding, or the employer may withhold from other compensation payable to that employee to satisfy this liability. The employer also gets a tax deduction for the compensation earned by the employee in the same year as the compensation becomes taxable to the employee.
Upon a later sale of the shares received by the employee following his or her exercise of the stock option, any increase in value of the shares following the date of exercise is taxed at capital gains rates, rather than at the higher ordinary income rates applicable to compensation. The employee selling those shares has earned the compensation paid upon exercise but can also participate in any future growth of the company as a shareholder.
Stock options are a creative and effective compensatory tool for startup employers to attract, retain and motivate the best available talent.
 Internal Revenue Code Section 409A (“Section 409”), relating to taxation of nonqualified deferred compensation, may subject stock options which are granted with a strike price less than the fair market value of a share of stock on that date to additional penalties. Valuation of private companies relative to the price of stock options for purposes of avoiding penalties under Section 409A is beyond the scope of this article but for our purposes, assume that a stock option is always granted with a strike price at least equal to the fair market value of the stock on the date of grant.