In most scenarios it benefits both the company and employees to give employees equity in the company. The employees are inspired by a sense of ownership and the company saves some cash. The trickier question is one of form: does the company offer stock options or restricted stock?
The mechanics of stock options are pretty basic: the company grants to the employee a call option to purchase - at a discount - X number of shares of the company's common stock. The discount is called the "exercise" (or "strike") price. Under this scenario, on the date the employee wants to sell and profit from his stock award, he purchases up to X number of shares and then turns around and sells the shares at a (presumably) much higher market value price and pockets the difference.FN1
Restricted stock, by contrast, is a straight gift of stock.FN2 The employee does not need to outlay any money. The "restricted" part is the caveat: the company retains the conditional right to purchase the stock back from you at some super cheap price - and usually this right expresses itself through a vesting requirement (i.e., although the stock is a straight gift it requires the employee to stick around the company for a certain period of time (market standard is 4 years to receive the full amount, with 1/4 of the total becoming available each year)).FN3
These structural differences implicate three main issues.
First, restricted stock gives the employee real as opposed to theoretical (in the case of options) value, and such real value is taxable to the employee upfront (stock options will not be taxed until the option is exercised (if ever)).FN4 So long as the initial value of the stock is low (such as in a start-up situation) this is probably to the advantage of the employee. The payment of that initial income tax aside, the employee won't pay any taxes until he sells the stock, at which point, so long as certain holding requirements are met, the tax will be capital gains rather than (historically higher) income tax.
By contrast, stock options will almost always result in ordinary income to the recipient when exercised (at least in the typical case where the underlying stock appreciates prior to exercise of the option).
Second, the grant of stock options require as a predicate the determination by the company of the "exercise" price. Because Section 409A of the Internal Revenue Code requires that the exercise price must be equal to (or greater than) the fair market value of the underlying stock as of the grant date, the company must coordinate (by the time of the grant) (i) an independent appraisal or (ii) if the company is an “illiquid start-up corporation,” a valuation of a person with “significant knowledge and experience or training in performing similar valuations” (who could be a company employee), which costs time and money.
Third, stock options give employees only the opportunity to benefit from the increase in the company’s value. If at a future date the market value of the shares drops beneath the exercise price per share (which is fixed to the time of the grant) then the stock options will be worthless.FN5
FN1. Two caveats here. First, in most cases, stock options are qualified/restricted by "vesting", which means that the right won't actually be triggered until a future date. Prevailing standards put the right to purchase 1/4 of the shares at the 1 year anniversary of the start date, 1/2 the shares become available to purchase at the 2 year anniversary, 3/4 on the third and all the shares on the 4th anniversary. In addition, most vesting provisions include acceleration clauses which accelerate vesting in the event of certain transactions (usually an IPO or acquisition). Second, more sophisticated service providers may exercise the option to purchase their stock before they intend to sell (because, essentially, the appreciation prior to exercise is taxed as income and the appreciation post exercise is taxed as capital gain).
FN2. Both stock options and restricted stock are sourced from the "incentive equity pool" of common stock reserved for employees. In most funded start-ups this pool will represent between 5-15% of the issued stock.
FN3. Restrictions can also be some sort of performance condition, such as the company reaching earnings per share goals or financial targets.
FN4. In most scenarios the employee will want to file here what is termed an "83(b) election" with the IRS so as to be taxed immediately upon the grant for the value (if any) of the restricted stock. If he doesn't make that filing within 30 days of the grant then he will be taxed incrementally over time as the restrictions to the stock disappear (i.e., the stock vests) - which can be prohibitively unaffordable if the stock appreciates significantly (yet remains illiquid).
FN5. Stock options have fallen out of favor during the last (markedly volatile) decade or so precisely due to this possibility.
No comments:
Post a Comment