Stock options can contain hidden limitations that your employer may not mention. It is important to understand the terms contained in stock awards to avoid surprises down the road.
At Gardner Employment Law, we appreciate the value of your stock. Your equity ownership may be a significant portion of your compensation. If you have questions about how your stock options affect your employment, give us a call.
What Are Employee Stock Options?
Employee stock options (ESOs) compensate employees and executives with potential equity ownership in the company. The company gives the employee the option to purchase stock for a specified price (usually lower than market price) within a limited period of time. Stock options are not the same as direct shares of a company’s stock but rather the opportunity to purchase stock at a preferred price. Management sets the price of the stock, known as the “strike price.” The employee must decide whether to purchase the stock by a specific date, called the “exercise date.”
Equity compensation may consist of stock options, restricted stock units, stock appreciation rights, performance shares, or actual shares of stock. Many times equity compensation depends on conditions or goals contained in a long term incentive plan. We discussed various aspects of ESO’s in Employee Stock Options.
What Is the Purpose of Employee Stock Options?
Employee stock options are given as an incentive and reward to employees as a way to motivate them to be more productive and to work towards growing the value of the company’s shares. “Options are the best compensation mechanism we have for getting managers to act in ways that ensure the long-term success of their companies and the well-being of their workers and stockholders,” as explained in Harvard Business Review.
The employer wants to retain good employees, and so ESO’s are awarded with a vesting period, meaning that the options will vest sometime in the future. Vesting means that the options transform into the actual right to purchase stock only after a stated period of time. Until your options vest, they have not yet been conveyed to you as a matter of right. Stated simply, unvested stock options are not your property. If the company terminates you before the vesting date, you lose the options.
An employer may reward hourly employees with stock options rather than paying the time-and-a-half for overtime, but based on strict criteria. Under the Fair Labor Standards Act, when computing “time-and-a-half” overtime pay an employer can exclude any value or income received by the employees as a result of grants of ESO’s from the employees’ regular rate of pay. “The purpose of a stock options provision is to allow nonexempt employees (employees eligible for overtime pay) to share in workplace benefits that involve their employer’s stock or similar equity-based benefits by excluding such benefits from an employee’s regular rate of pay,” as described by the Department of Labor.
Is There More than One Type of Employee Stock Option?
There are two general types of types of employee stock options plans:
- Non-qualified Stock Options: These options do not qualify for any special favorable tax treatment under the Internal Revenue Code. The word “non-qualified” refers to the tax treatment in that the value is taxed as ordinary income.
- Incentive Stock Options: Usually high level executives are awarded this type of option. The options can qualify for special tax treatment under the Internal Revenue Code and are not subject to Social Security, Medicare, or withholding taxes. However, to qualify incentive stock options must meet certain criteria specified in the tax code.
Can an Employer Insert a Non Compete Agreement in the Stock Option Award?
The short answer is yes. Oftentimes, employees assume that if an employer requires a non-compete agreement, the non-compete wording will be obvious and contained in an employment agreement. That is not always the case. In the landmark case, Marsh United States, Inc. v. Cook, the Texas Supreme Court held that a non-compete agreement contained in a stock option award was enforceable because the company’s goodwill was a business interest that was protected under the statute.
Companies utilize stock option awards to reward an employee for good performance. But since companies do not want their best employees to leave and go to work for a competitor, they may insert a covenant not to compete into the body of the award document. I have counseled clients who were so excited to be rewarded with equity ownership in the company, they did not notice the non-compete section contained in the grant.
What Happens to my Stock Options if I leave the Company?
If your stock options are vested, when you leave your company you likely have a short-term period during which you can exercise your remaining stock options, the “exercise period.” You must purchase the shares of stock at the price that is set in the award, the “strike price.” You may face a dilemma if the market is down and the strike price is higher than the market price. If this is the situation, the stock options are “under water.”
Even if you achieve vested options, they still can carry limitations such as “vested shares repurchaser rights” by the corporation, claw backs, non-competition restrictions on equity, or other negative restrictions. Also, a departing employee usually is required to first offer his or her stock to the company or major shareholders, called a “right of first refusal.” This prevents new owners from infiltrating into management. Texas law requires that restrictions on the transfer of stock rights must be stated in writing in the awards.
Another important fact pertains to “change of control.” You need to know whether the owners either plan to sell their business or are open to selling sometime in the future. If a company is sold, new management takes control of the operations. A company trying to sell the business frequently will insert restrictions on transfer of shares based on events related to a sale of the business. Management may use the limitations to prevent executives from leaving while the owners are “dressing up” the business for sale. Also, there may be limitations on transfer of shares until a date long after the sale of the business, to prevent executives from leaving the new owners. If there is a possible change in control of the company in the future, you need to understand your rights and limitations if that event occurs.
Over the decades this body of corporate law has grown. Many other nuances have become embedded in the law of corporate ownership, especially tax ramifications. This is a treacherous area.
Can an Employee Negotiate for Better Terms for Stock Options?
When stock options are a part of the compensation offered for a new job, you should discuss the terms of the stock options presented in the compensation package. Negotiation strategies will depend on the amount of leverage you have, as in any bargaining situation. The more value you bring, the more leverage you have. At a minimum, you should ask questions about what terms and restrictions are attached to the options being offered by the prospective employer.
Corporations create a certain number of shares that can be issued. The entire pool of one-hundred percent of stock consists of outstanding shares and issued shares. You want to know how many total shares of stock exist. In other words, you need to know what percentage your shares of stock will be. Some of the outstanding shares may be reserved. Sometimes corporations will later create additional shares to raise capital, which then dilutes the percentage of ownership. We discuss this topic in more detail in Equity Ownership.
We Can Help Understand Stock Options
Be careful of hidden restrictions in your stock options. If you have tax questions, see your CPA. If you have legal questions about your employee stock options, make Gardner Employment Law your first call.