By Moty Ben Yona, Esq. and Meital Dror, Esq.

Employee Stock Option Plans have grown significantly in popularity over the past few years, and present an effective way for companies to compensate and attract employees. According to Information Technology Associates, 15% to 20% of public companies offer stock options to employees as a part of their compensation package, and over 10 million employees receive them. Employee option plans have been praised as innovative compensation planning that helps align the interests of employees with those of the shareholders. However, there are those who condemn them as schemes to enrich insiders and provide a mechanism for companies to avoid their tax responsibilities.

Employee stock option plans are contracts between the company and its employees under which the employees are given the right to buy a predetermined number of shares from the company at a fixed price (often called the grant price, strike price, or exercise price) within a certain period of time. In most cases, the shares “vest” over a period of several years, meaning that the right to purchase a percentage of the shares at a fixed price becomes fixed in the first year, another percentage in the second year, and so on. The employee can exercise the option to purchase shares of the company at some point after the option vests or partially vests and before it expires.

Compensatory stock option plans are usually issued by the company to employees and consultants as payment for services and are part of an employment compensation package. Typically the stock option plan is subject to approval of the company’s board of directors and shareholders. There are two basic types of compensatory stock options: non-qualified stock options (NQO’s) and incentive stock option (ISO’s). NQO’s and ISO’s are subject to different tax treatment under the Internal Revenue Code (the Code), with the ISO’s receiving more favorable tax treatment if certain fairly rigorous requirements are met.  NQO’s receive less favorable tax treatment and, in some cases, punitive tax treatment under the Code.

NQO’s are subject to the general rules governing the transfer of property, other than money, as compensation for services rendered by an employee or other service provider (Code §83). They can also be subject to the deferred compensation rules, which can be punitive (Code §409A).  If the strike price of an NQO is less than the fair market value of the underlying stock on the date the NQO is issued, the employee could well owe taxes when the options vest, paying income tax imposed at ordinary rates (as well as social security tax) on the difference between the value of the stock on the day of vesting and the strike price under the option.  In such case, the employee would also have to pay a penalty equal to twenty (20%) percent of the tax owed.  For this reason, NQO’s are rarely ever issued where the strike price is below the fair market value of the stock on the day the option is issued to the employee.

If the NQO is issued with a strike price at least equal to the fair market value of the stock on the date of issuance, the employee generally does not owe any taxes when the options are granted, but is required to pay income tax imposed at ordinary rates (and social security tax) on the difference between the exercise price and the current stock price value when the employee exercise the options. NQO’s may be granted in unlimited amounts, and companies can deduct this amount as compensation expense. Any subsequent appreciation in the stock is taxed at reduced capital gains rates when the employee sells the shares but only if the employee has held the stock itself, not the option, for more than one year. The capital gain is also exempt from social security tax.  These options can be granted to anyone “providing services” to the company, not just to employees. Thus, those who serve on the company’s board of directors or even independent contractors can receive NQO’s.

Under the regime governing ISO’s (Code §422), no income tax is imposed when the options are granted or when they are exercised. The tax is deferred until the employee sells the stock, at which time the employee is taxed on the difference between the exercise price paid by the employee to acquire the stock and the amount realized by the employee on the sale of the stock. If the employee holds on to the stock acquired upon exercise of the option for a period that is at least two years after the ISO was granted and at least one year after the ISO was exercised, the tax imposed will be at the lower long term capital gains tax rate. If the employee does not fall within the mentioned timeframes, the sale is considered a “disqualifying disposition” and the gain realized at the time of the sale of the stock is taxed at ordinary rates.  Finally, it should be noted that the tax benefits attributable to an ISO are not available if the employee falls within the Alternative Minimum Tax (AMT) regime in the year in which the ISO is exercised. This is likely to happen if the gain realized by the employee at the time of the exercise of the ISO is significant compared to the employee’s other income in that year.  If the employee is subject to the AMT, he or she will be taxed as if the option was a NQO.

Among the requirements that an ISO must meet, the option price must be no less than the market value of the stock at the time of the grant, and it must require exercise within 10 years from the time it was granted. ISO’s are limited to $100,000 a year for any one employee, and may be confined to officers and highly paid employees.

Advantages and Disadvantages of Employee Stock Option Plans
A stock option is a promise for future payment, contingent on increases in the value of the company’s stock. As such, from the company’s standpoint, stock options do not have any immediate costs and will only have a future cost if the company is successful, at a time when the company can more readily afford the cost. Unlike other forms of compensation, which require the company to find the cash to pay its employees, stock options have no effect on a company’s cash flow. Consequently, start-up companies often use an employee option plan because it does not involve the immediate cash outlays that paying salaries imposes. Moreover, when employees exercise their options, the money that employees have to pay as the exercise price can lead to an inflow of cash for the company, albeit at a discounted price. Stock option plans also align the motivations of employees with those of the shareholders, giving the employees a larger incentive to try to raise share prices by contributing towards the company’s success. From an employee standpoint, stock options might be far more advantageous since they can be worth more than the company is able to pay in direct compensation. Although stock options have the effect of diluting the company’s earnings per share, many companies view this problem as of only secondary importance, especially during their initial stages of growth.

On the flip side, if the value of the company’s stock drops, then so does the value of the options. Employees, who have accumulated substantial amounts of stock or options, might be subject to a sharp decline in their value in very short periods of time in some cases, such as during severe market downturns and corporate turmoil. When company stock declines in value, it can leave employees feeling discouraged and lead to reduced productivity. Depending on the reason for the drop in the stock’s value, the lack of employee motivation could drag the company, and thereby its stock, down even further.

Practical Considerations
1. Careful Plan Design

Ordinarily, when designing an option plan, companies need to carefully consider the number of shares they are willing to make available to employees, who will receive the options, and the employment growth rate of the company so that the right number of shares are granted each year. A common error is to grant too many options too soon, leaving no room for additional options for future employees. The purpose of the plan is one of the most important considerations at the designing stage. Our experience indicates that it is easy to overlook specific issues that should be covered in the option plan, and one must not assume that a plan for executives has the same structure as a plan for all employees. Consequently, careful planning and reliable legal advice are key to establishing a successful option plan.

2. Plan for Acquisition
When writing an option plan, many companies work under the assumption that they will not be acquired. In reality, many companies, either publicly traded or private, go through an acquisition. The scenario of acquisition is one of the most common situations in which lawsuits relating to option plans arise. When there is a likelihood of an acquisition, many questions come to mind; will options immediately vest and become fully exercisable (making the company less financially attractive to a prospective buyer)? If options do not vest on acquisition, what happens to the unvested options? Can the unvested options be translated into options in the acquiring company’s stock? For options that are vested, are they immediately exercisable or will the employee receive options or shares in the acquirer instead? If options are exchanged, how will the exchange value be set?

Plans can provide a specific answer to each of the issues mentioned, however, that will limit the company’s flexibility during negotiations with the prospective buyer. In order to allow for more discretion, the plan should provide information regarding the decision making procedures and their basis. One suggestion, targeted to improve the employees’ confidence in this discretionary plan, is to involve a third party in the decision making process and not to rely solely on the senior management. A committee of outside directors or an independent fiduciary can be appointed as a third party by the company.

3. Specify Termination Rules
Termination, whether for cause or not, is a common area for employee lawsuits. An option plan should state that unvested shares are subject to forfeiture when an employee terminates his or her employment with the company. Employees will try to claim that their termination was inappropriate, or that the company is trying to prevent them from exercising the options by using termination. Ensuring that both the option plan and employment contract with the employee specifies the rights of the employee for unvested options if terminated can prevent litigation. A plan can also specify that unexercised but vested options are subject to cancellation by the company if an employee is terminated for cause. Such a provision should be carefully reviewed by an attorney to make certain it is consistent with the employment laws of the relevant state. Moreover, an option plan can also provide for cancellation of options in a situation in which an employee goes to work for a competitor, solicits the business of company clients and/or induces other employees to leave the company. However, these provisions need to be carefully structured in order to prevent them from running afoul of applicable labor law provisions which can vary from state to state.

In conclusion, employee stock option plans can provide companies with an incentive tool to attract qualified workers whom they otherwise could not afford to hire. However, any company considering implementing an option plan should bear in mind the tax implications and legal consequences of such a plan.

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