16 Nov The celebrated stock option: A Holy Grail for tech?
Madison, Wis. – The stock option is the Holy Grail for an employee in a technology company, carrying the promise of future millions. They can also be great for tech employers, who use them to attract and retain top-notch talent.
But unless you’re well versed in the vernacular of employee compensation, you might wonder exactly what a stock option is. In this column, I will offer an introduction to the stock option, as well as some of the more common alternatives to this popular benefit. Future columns will explore these forms of equity compensation in detail. This information with be useful to executives as they attempt to implement a company plan or, if you are an employee, negotiate the best deal for yourself.
So, what is a stock option? Simply, a stock option is a right to purchase stock at some point in the future. Stock options can be grouped into two general categories: (a) “qualified” or “statutory” stock options and (b) all other options, sometimes referred to as “nonstatutory” or “nonqualified” stock options (NSOs).
Of the two categories of stock options, NSOs are the classic type. NSOs come with few restrictions (although employers must be careful to abide by securities laws and the rules applying to deferred compensation). Generally, an employee who is granted an NSO will pay income tax on the difference between the option exercise price and the fair market value of the stock at the time the option is exercised.
For example, if you have an option to purchase 100 shares of stock for $10/share, but the stock is worth $100/share when you exercise it, you will owe income tax on $90/share when you exercise the option. That is, you will owe tax on $9,000. Moreover, this amount is recognized not as capital gain but as ordinary income. Thus, the NSO has two principal drawbacks: you will owe tax when you exercise the option, and it must be paid at ordinary income tax rates.
The statutory (or qualified) stock option addresses some of these concerns. It is just what it sounds like: a stock option permitted under a statute. In this case, we are talking about the Internal Revenue Code. The most common statutory stock option is the incentive stock option (ISO), which solves NSO drawbacks described above. ISOs are quite popular because, if structured correctly, the tax benefits to the employee are significant.
To use the same example as above, if you had an ISO with the same values, you would pay no tax when you exercised the option, and when you later sold the stock purchased with the ISO, you would pay long-term capital gains tax rates, not ordinary income tax rates. Of course, to get those benefits, you must satisfy a long list of statutory requirements, which I’ll cover in a future column.
Often, when companies and employees speak of stock options, they might actually be talking about other types of compensation that look and feel a lot like stock options. These plans are often considered because the company owners might not like the idea of giving up stock ownership to employees. Here are some of the stock option alternatives I’ll explore in future columns:
• Restricted Stock – Similar to the stock option, but the employee only gets the right to purchase restricted stock, usually designed to keep the employee at the company.
• Stock Appreciation Rights (SARs) – Instead of an option to purchase stock, the employee only gets a benefit based on the appreciation of the company’s stock over a period of time.
• Phantom Stock – Similar to SARs, a phantom stock plan mirrors the value of the company’s stock over time, providing a benefit to the employee if the stock appreciates.
• Straight Stock Purchases – A company can simply sell its stock to an employee, which can provide a company with more flexibility than the statutory alternatives.
• Employee Stock Ownership Plans (ESOPs) – Not often found in start-up companies, these Employee Retirement Income Security Act (ERISA) plans are designed to transfer ownership of a company to the employees in a more structured and universal way.
In the next few columns, I will look at several of these alternatives in more detail and, hopefully, provide a bit of insight into these popular plans.
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