For individuals considering executive positions in companies of all sizes, from startups to large public corporations, stock options can be a significant portion of their total compensation package. Stock options can be attractive for a variety of reasons. For one, they can offer tax-deferred compensation – under the Internal Revenue Code, the grant of a qualifying incentive stock option is a non-taxable event. For another, they offer the opportunity to participate in the company’s financial growth over time.
Take, for example, the option to purchase 1,000 shares of the company at a price of $10 per share – an accurate price based on the company’s current valuation. If the company’s shares are worth $50 in five years, the employee can exercise the option to buy all 1,000 shares and immediately reap the benefits of $40,000 in appreciation.
But, in many cases, employee stock options will be subject to what are known as “vesting” provisions. If a stock option is not “vested,” this means that the employee does not have the right to exercise it. In most cases, vesting occurs either all at once or over time. With the “over time” approach, the employee has a greater incentive to remain with the company. The longer the employee stays, the more options he or she can exercise, and the greater rewards he or she can reap from helping the company prosper.
Key Considerations for Employees with Unvested and Vested Stock Options
1. Stock Option Vesting Terms and Conditions
When negotiating a stock option agreement as an employee, it is critical to make sure you have a clear understanding of all of the terms and conditions that apply. Some of the key terms include:
- Option Grant – How many shares do you have the option to purchase?
- Option Price – What price-per-share will you have to pay when you exercise your option?
- Vesting Terms – When do your stock options vest? Do they vest all at once, or do you receive the right to exercise portions over time (e.g., 25 percent per year for four years)?
- Exercise – What are the requirements in order to exercise your stock options? Is a specific form of notice or form of payment required?
- Expiration – Will your stock options expire if you do not exercise them within a certain period of time?
- Death or Disability – Does the agreement provide protections for you and your loved ones if you die or become disabled and are no longer able to work for the company?
- Sale or Change in Control – How are your option rights affected (if at all) if there is a sale or change in control at the corporate level?
2. When to Exercise Vested Stock Options
Once your stock options vest, when should you exercise them? Everyone’s circumstances will be different, and you can never be certain that a particular investment decision will absolutely maximize your income potential. Some of the questions that you will need to answer when deciding whether to exercise your vested stock options (either in full or in part) include:
- What would your tax liability be if you exercised the options now?
- In which direction is the company heading? Is the company’s stock likely to increase in value over time? Or, do you risk losing the value of your options if you decide to wait?
- When do your vested stock options expire?
- Do you have an asset protection plan in place to ensure that your shares (or your income from selling the shares) are secure?
3. Leaving Before Your Stock Options Vest
What if you want to make a move before your stock options are fully vested? The answer to this question depends on a number of factors, including your reason for leaving and your current employment prospects and marketability. For example, if you are leaving your current company as a result of a dispute with your employer, you could have the leverage to negotiate for early vesting of your stock options as part of a settlement agreement or severance package. Conversely, if you are being courted into a new opportunity, you may be able to negotiate a signing bonus or other form of additional compensation to offset your losses from foregoing unvested stock options with your previous employer.
Granting Employee Stock Options as a Startup or Established Company
Are you wondering if your company should be offering stock options to potential employees? While granting stock options is a popular recruitment tool, especially for companies capable of luring top talent, it is not necessarily the best option for all businesses. Before you start putting stock options on the table, here are some key considerations to keep in mind:
- Is your company set up to offer stock options? Like all aspects of corporate ownership and governance, offering stock options requires your company to have the appropriate documentation in place. If your company’s governing documents do not account for the issuance of stock options, granting options to employees could wreak havoc on your corporate ownership structure. It is not too late to address the issue if your company’s current Shareholder Agreement and bylaws are inadequate, but you will need to amend them before you can put together a Stock Option Agreement to offer to prospective employees.
- Are you planning to seek angel or venture capital funding? If you hope to raise capital from angel investors or venture capitalists, you need to be careful to ensure that your option grants will not turn off potential investors. Generally speaking, potential investors will want to see that the option pool is as small as possible (they do not want to risk having their ownership shares diluted by vested employees). There is a careful balance between offering enough stock options to lure top talent and offering too many options to lure potential investors.
- Are you prepared to deal with the securities law compliance requirements? While compensatory incentive stock options are exempt from federal securities registration requirements, ensuring that your option plans qualify for this exemption requires careful planning and documentation. If your company offers options in violation of federal securities laws, the consequences can include a right of rescission for employee-shareholders, fines and other financial penalties, and the potential for federal prosecution.
- Is the timing right? Has your company shown enough potential that stock options are actually an incentive for prospective executive employees? Has your company’s valuation increased to a point where it is not financially viable to offer incentive stock options? There are right (and wrong) times to offer stock options, and vesting schedules can impact the viability of offering stock options as well.
- Is restricted stock a better option? If your company is still in the startup stage, offering restricted stock may be a more attractive alternative that offering unvested stock options. You can structure restricted stock offerings to vest immediately or in the future; and, with restricted stock, employees receive their shares immediately upon vesting rather than having to exercise the option to purchase. Restricted stock offerings can also offer tax advantages to employees (provided they file the Section 83(b) election). When structured appropriately, restricted stock grants can be viewed more favorably by outside investors.
Speak with an Attorney at Jiah Kim & Associates
If you have been offered a Stock Option Agreement, or if you are considering stock options as a tool to attract top talent to your company, we encourage you to contact us for an initial consultation. To speak with an attorney at Jiah Kim & Associates, call (646) 389-5065 or inquire online today.
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.