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Understanding
Stock Options for High-Tech Employment
By
Jay Hollander
Jay Hollander, Esq. is the principal of Hollander and Company LLC, www.hollanderco.com, a New York City law firm concentrating its efforts in the protection and development of property interests relating to real property, intellectual property and commercial interests, as well as related litigation.
The content of this article is intended to provide general information relating to its subject matter. Providing it does not establish any attorney-client relationship and does not constitute legal advice. Personal advice in the context of a mutually agreed attorney-client relationship should be sought about your specific circumstances. Summary: At
one time in the early days of the Internet economic boom,
stock options were considered the ultimate path to riches.
Options can still be an important part of an employment
package at a high-tech company, but they're no guarantee
of financial riches. This article explains the confusing
language and structure of stock options and how to decide
how valuable they may be.
Introduction
Up until this past spring, you couldn't read a paper, walk
down the street or watch television without hearing about the
latest millionaire, rising from nowhere to the top of the heap
through the magic of stock options. So tantalizing had they
become, especially in pre-IPO technology or dot-com companies,
that professionals and others in traditionally high-paying
professions like law, jumped ship to work for start-ups, and
employees in what had become a very tight labor market started
asking for stock options before considering accepting offers
from a particular employer. Even Congress has been considering
bills to extend tax-friendly stock option plans to larger and
larger percentages of company workforces.
Then,
March and April came and the market valuations of technology
companies fell off the proverbial cliff, plunging the value
of many of these stock options "under water," that is,
to a level below the supposedly favorable price where employees
had the right to buy them. In July of this year, the president
of Amazon.com quit to join another company, leaving a substantial
amount of such underwater stock options in his wake. Other
companies had to consider -- or take -- drastic steps to
stem the tide of disenchanted employees from returning
to the traditional workforce where they were paid 100%
in cash, with no risk.More recently, with some fits and
starts, the IPO market for technology companies has selectively
rebounded, once again fueling appreciation of, and demand
for, favorable stock options. In a topsy-turvy market,
just how do you figure out whether to demand or accept
stock options as part of your compensation? In a time of
substantial market volatility, how do you measure the value
of these options? And what will you do with them when and
if you get them?These are complicated questions with volumes
of books written about them. Tax attorneys and financial
advisors make good parts of their living figuring them
out and advising clients about them. Still, there are basics
to stock options that we'll discuss here, and, when we're
through, you'll know enough to ask intelligent questions
of your advisors, understand their answers, and be better
able to negotiate, whether you're an employer or employee.
Types
of Stock Options
The most basic part of the basics is
understanding what a stock option is and what kinds there
are. Simply, stock options give an employee the chance
to participate in the hoped-for appreciation of a company's
stock by being granted a right to purchase a predefined
number of shares of that stock for a set period of time
at a certain price, known as the "exercise" or "strike" price.
Options are given to inspire company loyalty and better
job performance and, as a result, there is usually a minimum
period of employment required for your rights in all or
part of the options to vest, that is, for you to be entitled
to exercise all or some of your options.There are two kinds
of stock options, the main difference between them being
their tax consequences to the employer and employee. Options
are either "non-qualified" options or "incentive" options.Non-qualified
options are often given to employees below key management.
Although the eventual anticipated difference or "spread " between
the strike price and its fair-market value may make it
worthwhile, employees given such "NSO's" pay through the
nose in taxes and often must pay cash or significant fees
upfront to take advantage of them.After their vesting period
is over, employees who exercise their "NSOs" are taxed
twice. First, they are taxed on the spread in the year
of exercise, even if they don't sell the stock when they
exercise the options. Because the spread value is considered
compensation, it is taxed at ordinary income tax rates,
instead of the lower capital gains rates. At the same time,
such employees often have to come up with the cash to buy
the stock at the exercise price and pay the taxes on it,
or borrow enough to do so. Under the tax rules, the employer
gets a tax deduction for the amount considered income to
the employee in the year of the exercise. The availability
of this deduction to the employer is one reason why employers
often prefer "NSOs."Ultimately, assuming the employee holds
the stock for a year, a long-term capital gains tax will
be due when the employee sells the stock.By comparison,
incentive stock options are thought to be more favorable
from an employee's point of view because, unlike the case
with NSO's, employees pay no tax on "ISO's" until they
are actually sold. And when they are sold, they will likely
be eligible for low capital gains tax treatment, because
of government rules regarding how long they must be held
to qualify as incentive options.Here's how they work. There
are no magic words needed for an option to qualify as an "incentive" stock
option. Instead, there are four main requirements to satisfy.
First, the option must be granted to an actual employee.
Second, it must be priced at or above the fair-market value
of the stock on the date the options are granted. Third,
the option term cannot last more than 10 years. Finally,
only $100,000 worth of such options can be exercised annually.
If the options don't meet the requirements, they will be
automatically considered NSO's, no matter what the documentation
calls them.If the employee holds the incentive options
for two years after their grant before exercise, and holds
the stock for another year before sale, he or she will
qualify for a long-term capital gains rate on the profit.
In this case, however, the employer receives no tax deduction,
as it does upon the exercise of NSOs.But, all is not rosy
with "ISOs" either, since the ultimate exercise of the
stock triggers "alternative minimum tax" analysis. The
AMT is basically a parallel method of calculating tax liability
that characterizes the ISO stock sale gain as a positive
adjustment to your income in the year of sale. Your tax
is figured both ways and the higher result becomes the
actual tax.As you might guess, there are strategies for
reducing or eliminating exposure to the AMT and close consultation
with a tax advisor is recommended for all those for whom
it is an issue.
Balance of Risk versus Reward
Assuming
one can get past the tax issues, there are still more basic
considerations affecting the value of stock options, having
to do with the strength of the company, timing of exercise
and sale, an employee's tolerance for risk and ability
to trade lower cash compensation in the short term for
the possibility of a big pay day later.Especially in start
up companies, employers love stock options since salaries
are greatly reduced in exchange for the potential gain
they represent and valued employees are held onto for a
longer period. Employees have also wanted them, at least
until this past spring, because of the chance for sudden
riches.Depending on the economic climate, though, hoped-for
IPOs can be postponed or shelved indefinitely. Even if
there is an IPO, any early run-ups in the stock may not
last and are vulnerable to shifts in investor sentiment
or economic slowdowns.By contrast, getting options in a
company that's already 'public mitigates some of the employee's
risks, at the possible cost of slower and less meteoric
stock price appreciation and still gives employers a carrot
to lure employees.
Valuation and Dilution
Another
big problem has to do with valuation. Since every share
of stock represents a percentage of ownership in the company,
the number of shares and value of the company's stock 'ultimately
translates into the value and offered strike price of options.
The difficulty, especially in pre-IPO technology start-ups,
is that valuation can be more of an argument than a demonstrable
fact. Anyone who's ever sought venture capital knows that
investors have very different ideas of a company's valuation
than do the founders. Before Internet mania, when companies
had revenues and earnings, these numbers could be compared
to public companies with similar results for a comfortably
close estimate of valuation. But where start-ups lack revenues
and/or earnings, there aren't always ready comparisons.There
is also the question of percentage of ownership and dilution.
While the amount of outstanding and issued shares in a
public company can be determined, privately held companies
don't always part with this information as easily. In contrast
to salary compensation, stock options are subject to dilution
or watering down of their value as a result of many common
types of corporate activities. For example, stock splits,
mergers, issuance of additional shares of company stock
or warrants or convertible securities all work to potentially
severely reduce the percentage of the employee's stake
in the company, as represented by the options.Luckily for
employers, and unluckily for employees, these activities
are generally legal, and employees' only real protections
are whatever anti-dilution provisions they can negotiate
in their particular option agreement or those that may
be contained in the company's employee stock option plan.
In start-ups, the founders get the most options and lowest
strike prices. This is understandable since they take the
most risk. Other top management and key personnel get another
chunk, and it is common to leave at least half of the outstanding
stock available for investors. This can, and often does,
leave employees with very small pieces of the pie, pieces
that are possibly further jeopardized by dilutive events.So,
if you are an employee deciding on whether to accept a
position where a big part of the payoff is in stock options,
how do you know whether your "favorable" strike price is
really so favorable? How do you even know if the deal you're
offered compares favorably with those given to other employees
of the company?If you're in a public company, it's relatively
easier since a lot of such information is filed with the
Securities and Exchange Commission and is available on
the Internet. If the company is private, it's much harder
and it is largely up to the employee's perseverance --
and management's willingness to divulge this kind of information.
Vesting,
Lock-Up Expirations and More
As if there weren't enough
headaches already, options are also subject to the uncertainties
of vesting schedules and lock-up period expirations.
Vesting, as explained earlier, refers to the time that
an employee must remain with the company before he or
she is entitled to exercise all or some of their options.
Lock-up periods, on the other hand, are usually creatures
of IPO's and prevent certain employees from selling their
stock until a certain date after a company's public offering.If
all employees' vesting periods expire around the same
time, or if the expiration of both the vesting and lock-up
periods come at the same time, the potential for a severely
depressed stock price increases dramatically, since there
would be a huge influx of selling in the company's stock,
all at the same time. Here, too, getting as much information
as possible, in advance, can only help in the decision-making
process.Of course, there are a host of other risks affecting
options, coming not from the company, but from the general
marketplace. A new or improved competitor, loss of market
share, deteriorating economic conditions and plain-old
investor psychology can wreak havoc with the price of
a stock and, in turn, the value of stock options.
The
full gamut of possibilities and strategies are much larger
than can be addressed here, but the subjects highlighted
in this article are among the fundamental issues that employers
and employees must consider to protect their positions
in offering or accepting stock options. It is a truly complicated
area where expert advice is highly recommended. Copyright © Jay Hollander, 2007. All Rights Reserved.
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