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Stock Option Plans

Article#1 - Overview

This series of articles explains how restricted stock, stock options, cash plans, phantom stock and stock appreciation rights really work for closely held companies, and what their real value is for the company and the employee. This subject – how closely held companies use employee incentive plans (like stock option plans) – is a tricky subject that few people know anything about. The articles in the series are: 1. Overview ◄You are here 2. Equity Plans – Stock Options and Restricted Stock 3. Stock Option Plans 4. Restricted Stock Plans 5. Company Buy-Back and Repurchase of Stock Options and Restricted Stock 6. Cash Plans, Phantom Stock Plans and Stock Appreciation Rights 7. Summary and Plan of Action I will focus on closely held, small to mid-size businesses. This could be a pre-IPO startup company or a family business, it doesn’t matter. Further, I gear this series of articles to the business owner. The employee is not my intended audience, although these articles will be very useful to the employee who might take the stock option. There are two general types of incentive plans available for you: cash plans and equity plans. In cash plans, you give cash to the employee. Usually you base the amount of cash given on the company’s performance, as for example, phantom stock plans and stock appreciation rights. If this is your preferred topic, go to article #6 – Cash Plans, Phantom Stock Plans and Stock Appreciation Rights. The second general category of incentive plan is the equity plan, either stock options or restricted stock. Equity means stock or ownership, so with an equity plan you give ownership in the company to the employees. I will talk about equity plans first. Without further ado, please go to the next article in the series, Equity Plans – Stock Options and Restricted Stock for an overview of equity plans.

Article#2 - Equity Plans, Including Stock Options and Restricted Stock

This series of articles explains how restricted stock, stock options, cash plans and phantom stock really work for closely held companies, and what their real value is for the company and the employee. In this article #2, I explain how you use equity plans, that is, stock option plans and restricted stock plans to reward and encourage your employees. Equity means stock or ownership, so with an equity plan you give ownership in the company to the employees. This article applies to both stock option plans and restricted stock plans. Here are ten key concepts for equity plans. (1) There are two types of equity plan – stock option plans and restricted stock plans. I discuss the former in detail in Article 3 – Stock Option Plans, and the latter in Article 4 – Restricted Stock Plans. (2) Stock isn’t money; it’s paper. The value of cash is fixed; the value of stock is unknown. Your upfront benefit in giving stock is that you’re not spending money today. Your risks are that, from today’s perspective, the employee might consider the stock to be worthless paper; but tomorrow the stock might have risen to a value much higher than a straight cash payment today. (3) An equity plan has two benefits for the employee, one economic and the other psychological. Regarding the economic benefits to your employees, they have a possible payday if the company is ever sold. Remember that you are a closely held company. This means you’re probably not going public. The employee/shareholder can receive annual dividends or distributions, but they likely are not high. The primary economic benefit of a minority stock holding is a payoff if the company is ever sold or merged. The employees usually must wait until someone is willing to buy the entire company before they can receive any money for their shares. Upon the sale of the company, the employee gets his share of the proceeds. Regarding the psychological benefit to your employees, they become stakeholders. For high level employees this can be very important. In fact, I’ve found that long-term managerial employees for small companies want equity, if for no other reason than face. It’s hard to be deeply involved in running a small business but have everyone know that you’re not an owner. (4) What does giving equity mean to you, the owner? First, you’re compensating employees without paying them cash. This is the main reason why the Silicon Valley pre-IPO companies love stock options. But the equity is still worth a lot to you, the owner of the company, because you’ll be sharing ownership of your company with other people. Your ownership will be diluted, and you will now have minority shareholders. Minority shareholders can be a real pain in the neck, as I explain next. (5) Minority shareholders are a pain in the neck because: They have rights under CA law. They demand things from you, and if you don’t give in, they threaten to sue you. You have to submit certain corporate actions to their vote. You have to open your books and records to them. When you ultimately sell your company, you might want to do so by a sale of 100% of the company’s stock, at which point you’ll need the minority shareholders to consent. You, as a majority shareholder, will owe fiduciary duties to your minority shareholders. Are you willing to grant these rights to your employees? Many small business owners hear this list of rights and decide, “I’ll just give them cash instead of equity.” A shareholder is a mini-partner, and partners can give you more headaches than anything else. I always say, “you don’t need enemies so long as you have partners.” (6) Have a plan about the maximum aggregate equity percentage you will give to employees over the next 5 or so years. Know where you are going. When you grant equity, you dilute the percentage interests of all existing shareholders, including you. Be sure that you are willing to do this. Think about dilution over the short term and over the long term. The best way to do so is to determine the maximum percentage of stock that you are willing to give to the employees as a group, over the next 5 to 10 years. Then allocate this number among the types of employees. In this way, you control how the plan dilutes your ownership interest in the company. (7) Be Stingy. Given that your company is closely held, it is extremely important that you selectively grant stock – you can’t give stock to just any employee. For you, options are not a cash substitute, and you can’t go around giving options to everyone. You must strictly control the process of granting equity. Besides avoiding the problems that shareholders can give, you also want to avoid all of the administrative hassles that come with a lot of shareholders. Also, if you’re an S corporation, your cap is 35 shareholders, and you can’t have non-resident aliens as shareholders. (8) Vesting. When you give stock options or restricted stock, the employee doesn’t really get the stock (i.e. vest in it) until he has worked for you for a number of years. (9) Get your stock back when the bum quits. This may be the key to equity incentives for closely held corporations. I discuss this at length in Article 5 – Buy-Back and Repurchase of Stock. (10) Do it right the first time. It’s expensive to have me fix a bad plan; it’s cheaper to do it right the first time. You should hire an attorney to help you with all of your employee incentive and stock option plans. If you want to read more try my main page, Business Lawyer. From there you can link to other pages and articles of interest.

Article#3 - Stock Option Plans

This series of articles explains how restricted stock, stock options, cash plans and phantom stock really work for closely held companies, and what their real value is for the company and the employee. In this article #3, I explain how you use stock option plans to reward and encourage employees. In the prior article, Equity Plans – Stock Options and Restricted Stock I introduced ten basic concepts for all equity plans, whether stock option plans or restricted stock plans. You should understand the prior article before moving on to this article. STOCK OPTION PLANS WORK WELL FOR A LARGE AMOUNT OF EMPLOYEES The key concept to remember about stock options (as opposed to restricted stock) is that they work best when you want to bring a larger number of employees onto the team. You’re giving equity in small pieces to a number of employees. Stock option plans involve a lot of paper and administration. They also require a filing with the State of California and the payment of a filing fee. For these reasons, stock option plans cost a few thousand dollars to implement. You need a large number of option grants to justify this expense. VESTING The options vest over a term of years. A common structure is to have the options vest over 4-5 years with a 1 year “cliff” and monthly vesting thereafter. Let’s assume you use a 5 year vesting schedule (4 or 5 years is standard). This means that the employee will not receive any options until the end of the first year (the cliff year). At the end of the cliff year, the employee will receive 1/5th of the total amount of options. After that, the employee will receive, every month, 1/60th of the total amount of options. At the end of 5 years, the employee will have vested in all the options that you granted to him. EXERCISE PRICE All options have an exercise price. The exercise price for options is the fair market value of the underlying common stock on the date of grant of the options. Your board of directors determines fair market value in its reasonable discretion. Hence if on the date of grant of the options your common stock is worth $1 a share, then the exercise price will be $1 a share. ISOs AND NSOs Options come in two flavors: incentive stock options (ISOs) and nonqualified stock options (NSOs). In brief, you usually give ISOs to your employees and NSOs to your consultants. ISOs are tax-beneficial to the employee because they convert ordinary income into long-term capital gains. NSOs are tax-beneficial to the company because it usually can take a deduction for the compensation deemed paid upon exercise of an NSO. I will not go into further detail because the tax laws for ISO and NSOs are too complex for this introductory article. You can find countless articles on the internet about them, however. REPURCHASE OF STOCK Get your stock back when the bum quits. For all vested options and purchased stock, you will want the ability to take the stock back from the employee when you fire him or he quits. I discuss this at length in Article 5 – Company Buy-Back and Repurchase of Stock Options and Restricted Stock. SUMMARY OF STOCK OPTION PLANS With a stock option plan, you give a number of employees equity in installments over a number of years. The employees pay to exercise the options. Once the options vest and the employees exercise them, they get real stock. At that point they are real shareholders.

Article#4 - Restricted Stock Plans

This series of articles explains how restricted stock, stock options, cash plans and phantom stock really work for closely held companies, and what their real value is for the company and the employee. WHERE YOU ARE IN THE SERIES In this article #4, I explain how you use restricted stock plans to reward and encourage employees. In the previous Article #3 – Stock Option Plans I introduced stock option plans. In Article #2, Equity Plans – Stock Options and Restricted Stock I introduced ten basic concepts for all equity plans, including restricted stock plans. You should understand the ten basic concepts before moving on to this article. BASICS OF RESTRICTED STOCK Restricted stock plans work best for a small, select number of employees. These people are high level management; they are not rank-and-file employees. Think of restricted stock plans as one-off deals for individual employees. From my perspective as a lawyer there are many differences between a stock option plan and restricted stock. But for you, the business owner, the primary difference is price and convenience. As between an option plan and restricted stock, restricted stock usually costs less and is easier to administer because less paper is involved. Further, if the restricted stock plan requires a California filing, the filing fee usually will be less than for an option plan. PRICING OF RESTRICTED STOCK With restricted stock plans, you grant stock directly to the employee. You directly issue all of the stock to the employee at the then-current fair market value of your company’s stock (determined by the board of directors in its reasonable discretion). If the employee cannot pay the entire purchase price for shares up-front, you can accept a promissory note from the employee. If you want to give the stock for free to the employee, the gift will be ordinary income to the employee, that is, the employee will have ordinary income for tax purposes equal to the fair market value of the stock. VESTING OF RESTRICED STOCK The employee’s restricted stock likely will be subject to vesting, similar to options. For restricted stock (unlike options), vesting really refers to the lapse of your (the company’s) right to repurchase the stock. That is, when restricted stock is said to vest, it really means that the company’s right to repurchase the stock has lapsed. This is a technical difference between restricted stock and option. You can ignore these technical points, however, because the outcome should be the same whether you use restricted stock or options. REPURCHASE OF RESTRICTED STOCK The key to restricted stock is that you retain the right to repurchase the stock if the employee ever leaves the company. Using the closely held company model that I’ve developed, you would repurchase 100% of the stock if the employee leaves the company, and you would pay a fair price for the stock. I discuss this at length in my next article, Company Buy-Back and Repurchase of Stock Options and Restricted Stock.

Article#5 - Company Buy-Back and Repurchase of Stock Options and Restricted Stock

In this article #5, I explain how you take back an employee’s stock when the person quits or you fire the person. In the previous articles #3 – Stock Option Plans and #4 – Restricted Stock Plans, I introduced stock option plans and restricted stock plans. Don’t forget article #2, Equity Plans – Stock Options and Restricted Stock. In that article I introduced ten basic concepts for all equity plans, including restricted stock plans. You should understand the ten basic concepts before moving on to this article. BUY-BACK OF STOCK Now we’re getting to the good stuff – the key to how closely held companies should use restricted stock and stock options. The problem is this: the employee receives stock but later leaves the company. The employee becomes a minority shareholder who no longer has an everyday stake in the company. Remember from article #2, Equity Plans – Stock Options and Restricted Stock the essential nature of all shareholders – they are a pain. The situation is worse if the employee leaves the company on bad terms. The solution is for the company to buy-back the employee’s stock when the person leaves the company. The company’s buy back right would apply to all shares, even vested shares. The buy back right would apply when the employee leaves the company for any reason whatsoever. So when the employee says “bye” you say “buy-back.” THE BUY-BACK PRICE In buying-back an employee’s shares, the real issue is the repurchase price. California law prevents a company from taking back an employee’s shares for free. You have two choices here: (1) pay the original purchase price for the stock or (2) pay the current fair market value of the stock at the time of the buy-back. Assuming that the company will grow and increase in value, the original purchase price should be lower than FMV at the time of buy-back. Which price do you pay? In brief, you pay original purchase price for unvested stock and FMV for vested stock. The bottom line is that when the employee leaves, he loses all his shares. But you pay him a fair price for the shares. Hence you return the money (if any) the employee gave you for unvested stock; and you pay the employee FMV for his vested stock. Note that your documents should give your board of directors the exclusive right to determine FMV. You should hire an attorney to help you with your stock option plan or restricted stock plan. It’s expensive to fix a bad plan; it’s cheaper to do it right the first time.

Article#6 - Cash Plans, Phantom Stock Plans and Stock Appreciation Rights

In this article #6, I explain how you use cash plans, phantom stock plans and stock appreciation rights. To review, there are two types of incentive plans: equity plans and cash plans. I discussed equity plans in prior articles #2-5. With an equity plan, you give employees stock options or restricted stock. Equity means ownership, so with an equity plan you give ownership in the company to the employees. With cash plans, you give money to the employee, not ownership. With a cash plan you can give the employee similar economic benefits as stock, but you don’t actually give stock. There is good and bad in this – you avoid the hassles of employee / shareholders, but you miss out on the psychological benefits of employee / part-owners. For more on this topic, see Article #2 – Equity Plans – Stock Options and Restricted Stock. You can base the amount of cash given on the company’s performance. You also can give cash in a way that tracks the performance of the company’s stock as with a phantom stock plan or stock appreciation rights. WHEN WOULD YOU USE A CASH PLAN? Cash plans are useful when: *** Cash provides more incentive than stock. Your employees might not be interested in a small ownership interest; some folks just take cash, thank you. *** You want to give economic benefits that are not tied to stock value, for example performance based bonuses for a division or even an individual. *** You don’t want to dilute existing shareholders, for example, you envision a big payoff when you sell the company and you don’t want to share. CASH PLANS In cash plans, you give cash almost like a bonus. You base the payment on some performance milestone such as company earnings or increases in the value of the company’s stock. Most cash plans also provide for lump sum payments at the sale of the company. Hence you can give the employee (1) ongoing payouts based on how the company is doing (like stock dividends and distributions); and (2) a final payout at the sale of the company (which is the ultimate payoff for shareholders). These payments mimic very closely the economic benefits of stock. HOW TO STRUCTURE THE CASH PLAN Most home-made cash plans run into problems here: Do you give a percentage of actual net profits on the financial statements, or a special pool of net profits set aside for employees? Be very careful when giving employees a direct percentage of the company’s earnings or profit (say 1% of net profit as it appears on the company’s financial statements). A percentage of earnings or profits can never be diluted, which means you are stuck with the grant so long as the employee stays around. For example, the company may grow by 100 employees and earnings might increase 20 times, and the original employee will still be taking his 1% cut of earnings just like before. But the pie has gotten a whole lot bigger, which means he gets more than his fair share and he squeezes other people out of their share. The best way to take growth into account is to set up the cash plan like a stock option plan. It’s a little complex to explain, which means a downside is that it will be hard to explain to your employees. The basic idea is that the employee doesn’t get a straight percentage of profits. Instead he gets something called a “unit.” The unit applies to something I like to call the “employee pool.” The employee pool gets the direct percentage of net profits, say 25%. So the employee might have 100 units in the pool, which would give him a share of the 25%. Now, as you bring in more employees, you issue more units. The effect is that you dilute the original employee’s share in the 25%. This works like equity plans where the employee / shareholder is diluted by new grants of stock. PHANTOM STOCK PLANS AND STOCK APPRECIATION RIGHTS Stock appreciation rights and phantom stock are frequently used interchangeably. I’ll call these types of plans “phantom stock plans” for short. Phantom stock plans grant “units,” which are treated like shares of company stock. The units track the company’s stock, and increase or decrease in value along with the stock (plus any dividends that your company might pay). The units vest like stock options, and the employee can convert vested units into cash. The units usually vest after completion of a set number of years of employment, upon a sale of the company or upon a public offering of company stock. The employee forfeits the units at termination of employment. For small to mid-size companies and startups, the real value of a phantom stock plan will come at the sale of the company. At this point, phantom stock plans act very similar to stock options and restricted stock, because the employees receive a payment from the sale of the business. The downside to phantom stock plans, however, is that your employees might not be familiar with them. You have to explain the value of the plan to your employees, and they might not understand or care. You should hire a competent attorney to help with your cash plan, phantom stock plan or stock appreciation rights. Plaintiff lawyers who represent employees love to see an unclear compensation package. Remember that bitter employees love to sue, and their lawyers will take full advantage of any confusion that may exist as to what you owe the employee.

Article#7 - Summary and Plan of Action

This is article #7 of a 7 article series. In this article #7, I give you 7 steps to implement your stock option plan, restricted stock plan, cash plan, phantom stock plan or stock appreciation rights. To review, there are two types of incentive plans: equity plans and cash plans. I discussed equity plans, that is, stock option plans and restricted stock, in prior articles #2-5. I discussed cash plans, phantom stock plans and stock appreciation rights in article #6. STEPS TO TAKE IN IMPLEMENTING YOUR PLAN Think hard about your company as it exists today, and as you want it (and can realistically expect it) to be 5 years from now. Think about the number of key employees that you have and that you’ll need over the next 5 years. Talk to your employees, and find out what they want. Cash or equity? If they want cash, use a cash plan or phantom stock / stock appreciation rights plan. If they want equity, then: *** If the number of key employees is small, use restricted stock for that handful of employees, and use discretionary bonuses or maybe a cash plan for everyone else. *** If the number of key employees is larger, use a stock option plan. Again, you can use discretionary bonuses or maybe a cash plan for rank and file. Please consult an attorney because it isn't that easy.

Early Exercise for Your Company's Plan

WHAT IS EARLY EXERCISE? An early exercise provision works as follows. Let’s say a key employee or consultant is granted 100,000 options with an exercise price of $1 per share, vesting 25% at the end of each year for 4 years. An early exercise provision in the option plan would allow the optionee to buy all 100,000 shares immediately, even though the optionee will only vest in 25,000 shares per year. The company retains the right to repurchase the optionee’s unvested shares pursuant to the optionee’s vesting schedule. Usually the company will repurchase shares if the optionee severs his or her relationship with the company before the shares vest. This means that, by the prior example, the company could repurchase 100% of the stock if the relationship ends before the end of year 1, 75% before the end of year 2, and so on. The repurchase price for unvested shares is equal to the original exercise price, so the optionee has no opportunity to realize a gain on the unvested shares. EMPLOYEE OR CONSULTANT'S PERSPECTIVE For employee or consultant, it may be smart to take advantage of an early exercise provision. The basic reason is that, if the company is growing, then the value of its stock will increase over the vesting period, and therefore the spread (fair market value less exercise price) will also increase. Employees and consultants look to exercise early when the spread is low, that is, the fair market value of the shares is about equal to their exercise price. For early exercise, the spread could be as low as zero. If the employee or consultant waits and the value of the company increases, then the spread will also increase. ***For an employee with an incentive stock option (ISO), to exercise early when the spread is minimal can reduce the employee’s exposure to the alternative minimum tax (AMT). If the employee exercises the option after the stock goes public (we should all be so lucky) the spread will have gone sky high and the employee’s AMT may be a significant tax burden. ***A consultant with a nonstatutory stock option (NSO), upon exercising his or her option, will recognize ordinary income on the spread. The advantage of early exercise, then, is that by exercising when the spread is minimal, the consultant recognizes a minimal amount of ordinary income. The spread is later taxed at the capital gains rates when the consultant ultimately sells the stock. BUT BE CAREFUL Early exercise only works if the optionee makes his or her 83(b) election within 30 days of exercising the option. If the optionee forgets to make the 83(b) election (which often happens), then the optionee loses most of the tax advantages mentioned above. In addition, for both employees and consultants, early exercise is a gamble that the company will increase in value. At initial startup, there is a better chance of success, because then the company’s value is minimal. Recent events, however, give us reason to be wary of such investment risk. THE COMPANY'S PERSPECTIVE So why do legal advisors have reservations about early exercise? Because early exercise adds complexity to the company’s stock option plan and increases the company’s administrative burdens. In general, my experience has been that most companies have difficulty keeping up with the administrative burdens of even the simplest of option plans. Increasing the complexity of the option plan only increases the risk of more company slip-ups. ***The company usually will hold unvested shares in escrow, and will release them only upon vesting. This creates more work for the HR and payroll departments. ***Companies frequently forget to repurchase unvested shares upon termination of an employee or consultant. Those persons carry a grudge, and reappear later to claim their rights in the shares – especially if the company has increased in value. ***Upon early exercise, each optionee becomes a shareholder and has full voting rights as a shareholder. The increase in shareholders can be inconvenient (and sometimes unworkable) for the company. ***Many optionees simply do not understand the tax implications of early exercise, for example, optionees often fail to timely make their 83(b) election (see above). Option plans can be complex enough without adding early exercise. The key is to have a well-documented and well-administered plan. If an employee wants to take advantage of early exercise, it seems logical that with their own money at stake, there’s more of a commitment. Investment has a way of motivating people. Our view is that a win-win occurs with the early exercise opportunity. ISO plans are all about tax breaks, and an early exercise provision substantially increases the tax benefit when compared to exercising later, when the high stock price makes the economics and tax issues very complex. In many instances, the initial exercise price is very low and taking advantage of the early exercise provision place only a slight burden on the company as compared to the tax benefit to the employees. CONCLUSIION Whether or not to permit early exercise is obviously a complex issue. Needless to say, the company should consult its legal and tax advisors before doing anything.

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