Granting Stock Options

Is your company granting stock options? Here are some of the key legal considerations we will discuss with you:

Why are stock options important for your company?

Stock options and other forms of equity compensation are an essential form of employee incentive for many companies. For startup companies, options represent a currency necessary to supplement salary which may be limited by available funds (but note that stock options or restricted stock awards do not satisfy minimum wage requirements applicable to all businesses).

What is the difference between common stock and stock options?

Common stock is the basic unit of ownership of a corporation, denominated in shares. Stock options are not stock but represent a right to purchase stock at a specified price per share for a certain period of time (typically 5 – 10 years) and subject to certain conditions (typically continued employment with the company for 1 – 5 years). For example, an option might represent the right to purchase 1,000 shares of common stock at a price of $0.10 per share for a period of 10 years, vesting during continuous employment at the rate of 1/4 of the shares after one year and 1/48 of the shares per month of thereafter (fully-vested after 4 years).

What is the difference between incentive stock options and nonstatutory stock options?

Incentive stock options (ISOs) must satisfy a set of special requirements under the U.S. Internal Revenue Code. Options that do not satisfy these requirements are referred to as nonstatutory or nonqualified stock options (NSOs). See my article, Differences between Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs). Both kinds of stock options work the same way for purposes of corporate law.

How is the exercise price determined when granting stock options?

The exercise price of a stock option must be at least 100% of the fair market value of the underlying shares on the date the option is granted. For incentive stock options (ISOs) granted to an individual who owns more than 10% of the company, the exercise price must be at least 110% of the fair market value of the shares on the date of grant. The determination of fair market value for purposes of stock option grants may require an appraisal from an independent valuation consultant.

When can stock options be exercised?

Options are usually not exercisable until the underlying shares have vested (no longer subject to repurchase by the company at cost – see discussion of restricted stock below). Some options contain an “early exercise” provision. Early exercise options allow for the purchase of unvested shares, which then work much like restricted stock. Unvested shares remain subject to the right of the company to repurchase the unvested shares at cost (equal to the original exercise price).

What is a typical vesting schedule? What happens upon termination of employment?

A common vesting schedule provides for 1/4 of the shares to vest on the first anniversary of employment and 1/48 of the shares to vest each month of thereafter (fully-vested after 4 years) subject to continuous employment during the vesting period. Unvested options terminate immediately upon termination of employment. Vested options typically expire 1 – 3 months following termination of employment unless exercised within that time.

How is the exercise price paid?

In most cases, the exercise price for the shares underlying a stock option is paid in cash or by check. Many stock option plans also allow for “cashless” exercise, for instance by surrender of a sufficient number of other shares already owned by the option holder or by “net” exercise (also called “immaculate” exercise). A net exercise provision allows the option holder to exercise by surrendering a portion of the underlying option shares to pay the exercise price, based on an increase in the value of the common stock since the option grant date, and avoids the need to pay the exercise price in cash (although fewer shares are received because some are used to pay the exercise price). The use of ISO shares to pay the exercise price in a net exercise is deemed to be a disqualifying disposition of the surrendered shares because those shares have not been held for 12 months. For more information about holding periods, see my article, Differences between Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs).

What documents are necessary when granting stock options? What approvals are required?

Typical stock option programs are based on an equity incentive plan document which governs all equity awards under the plan, and individual stock option agreements for each grant of an option to an employee or consultant. Plans generally allow for multiple flavors of equity compensation, including stock options and restricted stock purchase agreements. The equity plan itself must be formally approved by the board of directors and by the shareholders of the company. Each award of individual stock options under the plan must be formally approved by the board of directors. We prepare all of the necessary documents in connection with stock options and restricted stock, including the equity incentive plan, the stock option agreements or restricted stock purchase agreements, the board and shareholder approval documents and the securities notice filing required under California law.

Are there tax issues for the company and the recipient of equity compensation?

The tax treatment of equity compensation is a minefield for both companies and employees. Most equity compensation plans provide for the issuance of ISOs, NSOs, restricted stock and other forms of equity awards. Each form of award is subject to different tax rules. Many stock issuances, including stock option exercises, can be taxable events for employees and trigger withholding and reporting obligations for the issuing company. ISOs are subject to very different tax treatment compared with NSOs. See my article, Differences between Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs). We help companies and individuals understand the differences between the various flavors of equity and counsel regarding the suitability of each kind in specific situations. A company should always advise an employee who receives or exercises a stock option, or who receives restricted stock, to obtain advice from the employee’s own tax advisor based on the employee’s individual tax situation.

What alternatives to stock options are available?

A restricted stock purchase agreement provides for the issuance of common stock, usually subject to vesting. Vesting is a right of the corporation to repurchase shares from a founder or employee at cost (often significantly less than fair market value) until certain milestones are achieved, such as continuous employment for a period of years. An important tax election under Section 83(b) of the Internal Revenue Code, must be made within 30 days of a restricted stock award (including the exercise of an early exercise stock option) in order to avoid future taxation as the shares vest. Employees should always consult their own tax advisor in connection with a Section 83(b) election because of the potential for additional tax in the year the election is filed.

How can we help your company with stock options or other equity awards?

We assist with the approval, documentation, implementation and tracking of stock options and other forms of equity compensation for your company. We also explain different forms of vesting for stock options and restricted stock, and different forms of exercise provisions including early-exercise and net exercise stock options.