Also in this Issue:
-A Brief Guide to Stock Option
Taxation and A Few Illustrations
-Gifts of Stock Options for Estate
Planning Purposes
-Tips and Traps for Options in Real Estate Contracts
"Optional" Reading: Options
In this issue of The Springboard, each of the four of us discusses options. The articles written by Andy, Jeff and Tom contain information about STOCK OPTIONS, and Jonathan's article includes helpful tips about REAL ESTATE OPTIONS. Your feedback is important to us; please let us know if you find this information useful and if there are other general topics that you'd like to see covered in The Springboard.
The information contained in The Springboard is general, and while it is intended to present useful background material to our clients and friends, it is not legal advice and should not be relied upon in any specific instance or for any specific matter. Please consult with your counsel prior to making any decisions or taking any action in respect of the matters discussed in The Springboard.
STOCK OPTIONS: THE BASICS
by Andrew L. Dudnick dudnick@ddrs.com
Executives looking to join a new company are almost invariably offered a compensation package which includes a significant equity component. I am frequently asked such questions as:
"Is an option for 10,000 shares the right amount?" or the variant "I’m taking a big pay cut to take this job but they’re making it up with options--do these 50,000 shares make up for the cash hit?"
"It’s a non-qualified option--do I care?"
"The new company has given me the choice to take the equity as restricted stock or as an option--what should I do?"
"What happens to my options if I am terminated without cause? Does it matter if I later go work for a competitor?"
These are all excellent questions. In this issue of the Springboard, we will attempt to answer these (and other) questions. Understand, however, that every situation has at least some unique elements, and that the complete answers to these questions involve a complex, intricate analysis and understanding of corporate, securities, commercial and tax laws as well as familiarity with accounting rules. Accordingly, this issue contains some general answers to common questions, but you really should seek professional advice for any given situation you face.
First, some basics about stock options. A stock option is a contract between you and the company you work for. This contract allows you to purchase a certain number of shares of the Company’s stock (the number typically varies depending on your importance within the organization) at a certain price (typically, but not always, the fair market value at the time your option is granted to you) within a certain time frame (typically, but not always, between 5 and 10 years, but ending upon employment termination). Because the stock is purchased at your option, you have a risk-free chance to participate in the (hoped-for) rise in value of the company. The company likes to use this as a compensation method because (a) you will have a greater incentive to work hard to maximize the company’s value, and (b) the company may be able to conserve its cash by giving you options in lieu of some salary or bonus money that you otherwise might expect to receive.
When you first start to negotiate to work at a company, you might expect that part of the offer would include stock options. There is, to be sure, lore about the "correct" number of options (or more accurately, the correct percentage of company stock that should be offered as options). The variables include the rank of the position being offered within the company (obviously, CEOs expect a larger package than a VP); the importance of the particular position within a company (not all VPs are created equally--marketing may be more or less important than business development or engineering in a given situation); the company’s stage of development (start-ups offer far greater option packages than more seasoned companies to compensate both for the risk and the typically lower cash compensation); the company’s investors' views about management options (not all venture capitalists are created equal, either); and the option packages held by current management (it is difficult, although not impossible, to negotiate an option package that is more attractive than someone who outranks you). For this reason, the answer to questions about the “right” number of shares can be tricky, although there are rules of thumb for various positions (at least within Bay Area technology companies) which you can use as a starting point for negotiations.
A stock option is but one form of equity compensation for the executive; moreover, there are two kinds of stock options (qualified options, called "incentive stock options" or ISOs, and non-qualified stock options, called NSOs). Jeff Detwiler discusses these two types of options (which offer very different and important income tax consequences). With any of these forms of equity, there is much to evaluate and consider. The issues most often the subject of negotiations include:
Vesting. Vesting refers to the availability to exercise (or obtain the economic benefit of) your equity, typically as a function of how long you stay employed. Thus, the longer you stay, the more you vest, and the greater the percentage of the equity you were initially granted becomes available to you. Sometimes vesting can be a function of achieving milestones (e.g., product launch, revenue level, or patent procurement). The vesting schedule is generally negotiable at the outset, although some companies strongly resist any changes to their "normal" vesting rules. Some companies you are negotiating to join are sympathetic to arguments for more (or "accelerated") vesting of some or all of the options if you are terminated without cause or quit for good reason, since you may well have given up a significant amount of cash for your options (not to mention given up other significant business opportunities, including the one at your current employer) to take the new job and it wouldn’t be fair to have the economic equity rug pulled out from under you under those circumstances.
Termination. Most options terminate within 30 to 90 days after employment termination. This can work a real hardship on the employee of a privately held company who is terminated without cause, since that employee will have a short period of time (rather than the many years that were otherwise left before the option expired) to decide whether to put up the exercise money without knowing if the company will ever succeed and have a liquidity event (e.g. an IPO or sale of the business) by which the employee can realize some gain. This can be (and often is) negotiated at the outset to a longer period of time (in some cases to a number of years after termination). Understand, however that this post-termination exercise period extension may have adverse consequences (such as turning an ISO into a NSO).
Exercise Price. Most employees think of the exercise price as a given--it is whatever the fair market value of the stock is at the time the option is granted. And that is typically true. But the exercise price is also negotiable in at least two senses: first, with a private company, the fair market value determination itself is open to some debate (the company’s board could look for guideposts at the prices at which options were most recently granted to other employees; the prices at which stock was most recently sold to investors; an appraisal or valuation done by an outside firm; the company’s prospects; and any number of other variables) and a new employee can be in a position to argue for a lower fair market value based on those variables; and second, the option (if it is an NSO) does not need to be granted at fair market value--it can legally be granted at far below the fair market value. There are tax, securities and corporate law rules and guidelines, and accounting considerations, which impact on a decision to grant options at below fair market value, but it is absolutely doable and something to consider, especially if there is an hefty aggregate price to be paid upon exercise.
Deciding to Exercise. There are a host of factors to consider when you are deciding whether to exercise your option. Among the most important are personal financial and investment situations and goals (include estate planning goals and your personal cash needs), income tax consequences (including the often overlooked alternative minimum tax, or AMT), how long you expect to stay on the job, your employer’s future prospects, and the outlook for the stock market. You also should consider any unusual provisions in your stock option contract, such as a "clawback", which is the right of the company to recoup from you some or all of your stock option gain if you go to work for a competitor. And, you can try to negotiate advantageous ways to exercise your option without paying cash up front (e.g. using a promissory note, already-owned shares of the company’s stock, or even on a cashless basis in which you receive a net number of shares equal in value to the difference between the exercise price and the fair market value of the stock at the time of exercise). At a minimum you will almost always want to consult with your accountant before you exercise, and it is a good idea to create an exercise plan with your accountant and investment advisor (which will need periodic revision as circumstances change) when you are first granted stock options.
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