Some stock options have restrictions which are important to know

Do Stock Options Have Restrictions?

Your stock option award is a symbol of your success with the company, right? But did you read the “small print” in the stock option agreement that you signed?

Your stock options likely have restrictions. In this article we explain restrictions to employee stock options, a subject in which Gardner Employment Law is well versed. If you need guidance on your equity compensation, contact us.

How Do Stock Options Work?

Companies award employees the right to purchase shares of company stock to motivate employees. In “Employee Stock Options,” we provide a comprehensive explanation of how stock options work. Companies offer stock options as an incentive for you to remain employed, to perform better, or to work harder to meet certain goals. The options are a form of equity compensation. 

Unlike shares, stock options do not transfer ownership of the shares. Stock options give employees the right to buy shares of stock at a price set by the company, called the “grant price.” The grant price often is discounted to permit employees to purchase shares of company stock at a lower price than the market rate. You may also see this price referred to as the “strike price” or “exercise price,” as well. 

After you become the owner of the shares, the grant price will be compared to the then market price. If your company generates revenue which turns into profit, the market price of the stock will rise. If that is the case, you stand to earn a significant amount if you sell your stock. However, if the grant price ends up higher than the market price, your stock options hold no value. Your stock options are “under water,” as it’s called.

Companies use several different forms of equity compensation, such as restricted share units (RSUs), stock appreciation rights (SARs), employee stock purchase plans (ESPPs), employee stock ownership plan (ESOPs), stock options, and actual shares of stock. This article will focus on stock options and the restrictions they may have.

The company may award you the benefit of a long-term incentive plan or “LTIP” that contains the stock options. In the LTIP, the company sets out the guidelines to exercise your stock options. 

What Restrictions Prevent Me from Exercising My Stock Options?

The day you receive your options is the grant date. On that day, you do not actually own shares. For you to truly own shares, you must wait to exercise your options until they “vest.” When the right to purchase shares of stock vests, at that point you own the stock options. Other forms of equity compensation may have vesting requirements, such as vested RSUs.

Vesting requirements dictate how long you must wait or what else you need to do for the options to vest. The vesting requirements usually require you to remain employed with the company for a certain number of years or to meet performance goals. If your options require that you stay for a certain number of years, your stock options follow a vesting period or vesting schedule. 

Generally, a certain percentage of your stock options will vest on certain dates. The options vest in “tranches.” Each tranche of options carries the same grant date, expiration date, exercise price, and vesting schedule. These vesting requirements should be contained in your stock options certificate or stock options agreement. 

After the time of vesting, you have a set period of time during which you can exercise your option to purchase shares. This limited time in which to exercise your options to purchase shares is the “exercise period.” However, some companies have additional restrictions after you purchase shares such as a post-vest holding period. This means you cannot sell your new shares until the holding period is over. Even if there is no formal holding period, there usually is a certain expiration date after which your right to purchase shares will expire. If you wait too long to sell and your options expire, you lose any shares that you might have purchased.

There are also tax ramifications you should know. While tax law goes beyond the scope of this article, keep in mind the potential tax rate of your stock options, and talk with your CPA about the tax consequences. You typically pay tax at a rate based on whether the option is a nonqualified stock option (NSO) or incentive stock option (ISO). If the options are NSOs, any gain from exercising your options will be taxed like ordinary income.

The tax applies at the date of the exercise, not when the shares are later sold. If they are ISOs, the profit is taxed as capital gains taxes, which is a lower tax rate. Also, ISOs allow the employee to delay taxation after exercising the option until the date when the underlying shares are sold.

If you leave the company before your options vest or before you can exercise them, you will lose your stock options. You do not own unvested options. Therefore, it is crucial to understand your stock options and their potential restrictions.

How Valuable Are Stock Options?

Stock options and equity compensation can be an extremely lucrative form of compensation. Many major companies such as Google, Apple, and Amazon use equity compensation to incentivize employees to stay at the company. As Forbes reports, these executives typically earn millions of dollars from this compensation. At Apple for example, senior executives received $23-35 million from their equity compensation. 

There are some risks with stock options. As mentioned earlier, if the market price of the stock drops below the grant price you paid for the shares, then you lose money. Companies such as Netflix have hit massive downturns with their stock value. Because Netflix’s stock value dropped almost 70% since November 2021, the employees demanded more stock to offset the loss. Stock options are lucrative only to the extent that the company has good market performance.

Read the Back of Your Stock Certificate

You may assume that your employer provided you with the full picture in explaining your stock options, and you may have signed the option agreement without a second glance. Later when you purchase shares at the grant price, the proof of your ownership will be in the form of a stock certificate. If you do not read the agreement or the back of the certificate, this can be a major blunder when it comes to equity compensation. 

We had a client who did not realize that there were additional terms on the back of the stock certificate when he later purchased shares of stock. Although he spent a handsome amount to purchase a number of shares, the back of his stock certificate contained terms that essentially made the shares worthless. The writing on the back of the certificate referred to other agreements which were incorporated in the purchase. Later when he read the other agreements, he was surprised to learn that in reality he owned nothing.

It is imperative that you read any document that you sign and the back of your stock certificate because of a legal concept known as “incorporation by reference.” In “Are Unwritten Policies Enforceable,” we explain that documents which you did not sign can affect you. If the back of your stock certificate references an employee handbook or another contract, you must follow the requirements contained in those documents to sell your shares of stock. Even if the full explanation is not included within the stock agreement that you signed or on the certificate, requirements contained in the other documents that are referenced legally apply.

While there is potential for long term capital gains with stock options, remember there are potential risks, too. Some companies instruct lawyers to draft multi-layered, complicated agreements that are incorporated by reference. These agreements may have traps. What seems valuable could actually become a liability. 

That is why it is crucial to read all documents carefully before you sign any agreement. Otherwise, you may end up with worthless options or spend money you can never recover. If you are unsure about the potential risks of your stock agreement, consult an expert employment lawyer who has experience with stock agreements and stock options.

Contact Us About Your Stock Options

There are quite a few restrictions and requirements to exercising your stock options. Contact an expert employment lawyer to review your stock agreement before signing. If you need guidance on your stock options or equity compensation, contact us.

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