Employee Stock Options

Are you in discussions with an employer about stock options?  See an expert to know how to negotiate for the best possible advantage — and make sure that you understand what you’re being offered.  Give us a call.

What Are Employee Stock Options?

Companies offer stock options to compensate employees for the hard work they do to help make the company successful. Stock options are an excellent incentive to encourage that hard work when the company can’t offer the pay rate that employees expect right away. 

Legally, stock options are similar to contracts that give employees the right to buy shares of company stock at the grant price. The “grant price” is a pre-set price that the employee will pay for the stock. The grant price may also be called the strike price or the exercise price. 

Within the entire pool of stock shares, often there are different classes of stock, with some classes being more important, more valuable, or with more rights than others. For example, some shares may carry only equity or ownership rights but no voting rights. Or some classes may have preference at the time of pay-out. Also, the shares may be restricted as to how, when, or to whom they may be sold. So you need to understand what you are getting, an option to purchase what. 

How Do Employee Stock Options Work?

Company management decides under what conditions the employees will be offered stock options, which conditions are stated in the grand award certificate. Stock options carry a deadline for exercising the right to purchase company stock.  Once the deadline has passed, the offer is closed. It’s also common for stock option contracts to state that the employee’s right to exercise an option will expire once they leave the company.

Depending on how the company chooses to structure the options, the grant may be the option to purchase stock at a discounted price.  Or it may be the right to receive actual stock in the future without being required to pay for the stock if certain conditions are met.  Whether you will receive actual shares of stock or the right to purchase shares is up to management and will be stated in the grant.

The simplest and most common condition is requiring the employee to remain with the company for a stated period of time. To entice valuable employees to remain, many companies grant options that have several dates in the future. If the employee stays until each of those dates, the options will “vest” on each of the dates. Unvested options are not yours until this condition is satisfied. If you stay for the required period, then the options become vested and you then own vested options. 

Stock options typically are granted in installments, an increasing percentage of the options becoming vested typically over a period of years. This is called a “vesting period.”  The options remain unvested during that period.

There may be an exercise period, a period of time during which the employee must purchase stock at the grant price. This can be important when the company is publicly traded and the market price of the stock is fluctuating.  The employee tries to purchase the stock at the best price, of course.  If the market price is less than the grant price, that is not such a good deal. The stock is said to be “underwater.”

Types of Employee Stock Options

The different types of stock options carry different tax consequences.  It is beyond the purview of this article to discuss tax law.  However, generally companies offer two types of stock options—nonqualified stock options and incentive stock options.

Nonqualified stock options are the most common type. The term non-qualified comes from the Internal Revenue Code and refers to the fact that this option doesn’t qualify for specialized tax treatment with the IRS.  Non-qualified stock options are taxed as ordinary income.  

An incentive stock option is a corporate benefit that gives an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit. The profit on qualified incentive stock options is usually taxed at the capital gains rate, which is lower than the rate for ordinary income. Generally, incentive stock options are awarded only to top management and highly-valued employees. 

There are other types of options, such as restricted stock units, stock appreciation rights, performance units, and various others, which have different tax consequences that you need to understand.

Restrictions on the Acquired Stock

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 stock to the company or major shareholders, called a “right of first refusal.” 

Another important fact is 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. Frequently, the company will insert restrictions on transfer of shares based on events related to a sale of the business. If there may be a 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.

Why Contact a Lawyer

When you’re in discussions with an employer about a new job or a promotion into management, equity could be part of your compensation package. Make sure that you understand what you’re being offered.

Before you accept the compensation package offered, it is wise to see an expert employment lawyer who has experience in spotting loopholes and hidden legal restrictions. We’ve done that for many of our clients, and we can help you.  If you need help, contact Gardner Employment Law.

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