- Posted on: Jun 1 2022
Part 1 – Options
By: Wright Lewis [6/3/22]
Sharing equity (ownership) in a business with employees is not a novel concept. Entrepreneurs have been sharing equity with their employees for decades, but equity sharing has become more popular over the last two decades, driven at least in part by the Silicon Valley culture of high-growth startups. These high-growth startups are often operating on lean budgets, so employees receive compensation in the form of equity to make up for otherwise below-market salaries. The “Great Resignation” of 2021, where an average of just under 4 million employees quit their jobs every month, made attracting and retaining employees a top priority for businesses. According to the Bureau of Labor Statistics, over 4.5 million people quit their jobs in November 2021 alone. How can companies attract and retain employees in such a difficult labor market?
One tool that companies can deploy is equity sharing. A business may share equity to reward employees for prior contributions, create a sense of ownership, foster an entrepreneurial culture, and drive long-term goals and metrics. In the context of the Great Resignation, an equity sharing plan is also a way for a business to differentiate itself in order to attract and retain the most talented employees. Equity sharing plans take many forms, including sharing of actual equity of the business through stock purchases and grants, stock options, ESOPs, and profits interests, as well as equity-mimicking arrangements like phantom stock, stock appreciation rights, and change of control bonuses. This article is one in a series of articles that will delve into the different types of equity sharing arrangements. Regardless of the form of equity sharing arrangement, communication and inclusion are critical to the company getting the maximum benefit out of the plan. The company should consistently communicate the value of the plan to employees and treat participants like co-owners of the business by providing them with information about the business and consulting them so they feel included in the decision-making process. For simplicity, I use corporate terminology throughout this article (e.g., “stock” rather than “membership interests” as in an LLC), but the concepts generally apply to other forms of business entities as well.
The most common form of equity sharing arrangement is options. Options are rights to purchase a specific number of shares of a company’s stock, for a set price (the “exercise price”), within a particular amount of time (usually ten years). The exercise price is usually the fair market value of the underlying stock on the date of the grant. In publicly traded companies, the fair market value of the stock is readily determinable based on the market price, but in privately held companies the fair market value is less clear. In privately held companies, the company determines the value of the stock. The company may employ a third-party valuation expert to ensure that the fair market value is accurately determined and to take advantage of the safe harbor offered under Section 409A of the Internal Revenue Code of the United States (the “Code”). If the company is being sold, the sale price is used to determine the value of the stock. Options holders do not have dividend or voting rights, which are only received once the option is exercised and the underlying stock is acquired. Practically speaking, option holders benefit only from the company’s growth in value after the grant date. If the company’s value does not increase after the grant date, the options will expire worthless.
Option grants are often subject to vesting. Vesting is usually time-based (e.g., 25% of the options vest after 1 year of continuous service to the company, with 1/36th of the remaining options vesting monthly over the following 36 months), but can also be based on attainment of certain metrics by either the employee or the company (e.g., target sales revenue/growth for a chief of sales). Acceleration of vesting upon a change of control (e.g., sale of the company) is customary.
The amount of equity to set aside for options grants will depend on the business. Venture capital firms often require that a company set up an employee options pool as a precondition to investment. These pools range in size from 10-20% of shares of the company on a fully diluted basis. Otherwise, the number of shares a company sets aside for its options pool, and the amount granted to each employee, will depend on several factors specific to the company and its goals, including the anticipated contribution of the participant, the value that contribution will create, and a determination of an equitable share of that value.
There are two types of options: incentive stock options (“ISOs”) and nonqualified stock options (“NQSOs”). ISO’s are stock options that qualify for special tax treatment because they comply with the requirements of Section 422 of the Code. The requirements of Section 422 are numerous, including that ISOs: (i) can only be issued by entities taxed as a corporation (C or S), (ii) can only be granted to company employees (not consultants, advisers, or other service providers), (iii) must be exercised within three months of termination of employment (twelve months if the termination was due to the employee’s death or “disability” (as defined in Section 22(e)(3) of the Code)), (iv) must be exercised within ten years of the grant date, (v) must be held for more than two years after the grant date and the shares received upon exercise must be held for more than one year after exercise, and (vi) are only transferrable upon the death of the recipient. Additionally, the fair market value (as of the grant date) of ISOs exercisable for the first time in any calendar year may not exceed $100,000. The exercise price of ISOs granted to shareholders that own more than 10% of the company’s stock must be at least 110% of fair market value and must be exercised within five years after the grant date. The benefit of meeting all of these requirements is that ISOs are typically not taxable to the employee at exercise (unless the difference between the fair market value and the exercise price triggers Alternative Minimum Tax (AMT) for the grantee). Thus, assuming all of the requirements under the Code are met, the employee can exercise their ISOs without recognizing a taxable gain and begin their holding period for long-term capital gains treatment.
NQSOs are a more flexible type of stock option that does not comply with Section 422 of the Code. NQSOs can be granted to employees, outside directors, consultants, advisers, and other service providers. NQSOs with an exercise price equal to the fair market value of the underlying stock (as of the date of the grant) are not taxable income to the holder until exercised. Upon exercise, the holder recognizes ordinary income equal to the difference in value between the exercise price and the value of the shares on the exercise date (which is subject to withholding according to standard payroll procedures), and the company receives an equivalent deduction. As a result, NQSOs are rarely exercised until a liquidity event (e.g., sale of the company, IPO).
Options grants must be approved by the company (e.g., Board of Directors) and are usually granted pursuant to some combination of a stock option grant agreement, stock/option plan, and exercise agreement which set forth the specific terms of the option grant and the general rules that govern all options granted under the plan, and any stock received upon exercise of the option. Such provisions should include a right of first refusal in favor of the company (allowing the company the right to match any third-party offer to acquire the shares) and a right to repurchase the shares at the then fair market value in the event of an involuntary transfer (e.g., death or divorce of the stockholder).
To get the maximum benefit out of an equity sharing arrangement (through an option plan or otherwise) and attract and retain the best talent in a tight labor market, the emotional aspects of the plan are as important as the financial aspects. The company must ensure that the plan is thoroughly communicated and marketed to employees and prospects and that participants genuinely feel like they are owners of the business. The purpose of equity sharing is to fundamentally change how employees feel about the company they work for. Ideally, this will result in a financial benefit to the company manifested through higher productivity, improved morale, greater retention, and higher-quality applicants.