How to Get More Bang for Your Buck: Stock Options and Restricted Stock - 1 June 2009

How to Get More Bang for Your Buck: Stock Options and Restricted Stock

Equity
incentives, which include stock options, help cash-starved start-up
companies compensate employees, consultants and other service providers
without breaking the bank. Even if you don’t plan to hire employees
early-on, adopting an equity incentive plan is beneficial because you
can also grant equity as compensation for the work of consultants and
other service providers. Start-up technology companies typically
reserve 10-20% of the total equity of the company for incentive grants
pursuant to an equity incentive plan, but businesses that expect to
make significant hires early on may want to reserve a bit more (the
amount reserved under the plan can also be increased at any time, but
generally requires shareholder approval).

There are several forms of equity incentives, and it is important to
understand the tax and accounting implications of each in addition to
the impact each can have on the equity ownership of your company. This
post gives a high level overview of the most popular forms of equity
incentives among technology companies – stock options and restricted
stock – but while we note some basic tax considerations below, this
entry does not purport to explain the tax or accounting implications of
granting options or restricted stock. It
is very important that you consult with your professional advisors
before putting in place an equity incentive plan for your company or
making equity incentive grants. Also, this entry only concerns
private companies and does not attempt to deal with various issues that
publicly traded companies must address in connection with making equity
incentive grants.

Equity Incentive Plans and Grant Agreements

Equity incentive grants are usually made subject to various
conditions that are spelled out in an equity incentive plan (often just
called an “option plan”) or in the grant itself. The plan usually gives
the company’s Board of Directors, or a committee of the Board, the
power to make grants and determine the conditions of each grant,
including when the recipient’s rights in the grant are no longer
subject to forfeiture (called “vesting”) should the recipient’s service
with the company end. The grant may provide for vesting upon occurrence
of certain events, but most technology companies issue options and
restricted stock that vest over time. A common vesting schedule would
provide for a percentage of the options or restricted stock to vest
after one year, with the remainder vesting monthly or quarterly over
the following two to three years.

Options

A stock option gives the recipient (or “optionee”) the right to
acquire a set number of shares of the company’s stock (referred to as
shares “underlying” the option or “option shares”) subject to certain
conditions. The optionee pays nothing up-front for the option, but the
option does not confer on the optionee any benefits of stock ownership
- such as voting rights or the right to receive dividends - until the
underlying shares are purchased (also known as “exercising” the option)
by payment of a predetermined exercise (or “strike”) price for each
share. There are two types of options distinguished by their treatment
under the Internal Revenue Code (IRC) – nonqualified stock options
(NQOs) and incentive stock options (ISOs).

Nonqualified stock options may be granted to employees, directors,
consultants and other service providers, but when the option is
exercised the difference between the strike price and the then-current
fair market value of the underlying shares (called the “spread”) is
taxed to the optionee as ordinary income, subject to withholding, and
the company receives a corresponding compensation deduction. Any
further gain realized when the stock is sold is taxed at the applicable
short or long-term capital gains rate, depending on the length of the
holding period following exercise. Incentive stock options may only be
issued to employees,
but unlike NQOs the optionee does not recognize any taxable income when
the option is exercised (though the spread is taken into account in
calculating the employee’s alternative minimum tax, if applicable) and
instead only reports income when she sells the underlying shares, at
which time the entire taxable income (the difference between the sale
price and the strike price) is treated as long-term capital gain
instead of ordinary income. In order to realize the tax benefits of an
ISO, the optionee must not sell the underlying shares for at least two
years after the option is granted and at least one year after the
option is exercised. If the holding period requirements or other
conditions in the IRC are not met, then the option converts to a NQO
and the optionee is taxed accordingly.

Restricted Stock

Unlike options, which give the recipient the right to acquire shares
of a company, restricted stock is actual stock that comes with all of
the benefits of stock ownership. Restricted stock is subject to
conditions imposed by the company at the time of grant, including the
company’s right to repurchase the stock should the recipient’s service
with the company end before the restricted stock vests. Restricted
stock is usually issued in exchange for cash and/or services at a price
per share equal to or less than the stock’s fair market value, and the
recipient is required to pay any cash portion of the purchase price at
the time the grant is made. The default tax treatment for restricted
stock requires the recipient to recognize ordinary income as the
restricted stock vests (over time or upon the occurrence of specified
events) on the difference between the original purchase price for the
shares and their fair market value at the time of vesting. If the stock
is subsequently sold, the recipient must recognize a taxable capital
gain or loss on the difference between the sale price and the fair
market value of the stock at the time of vesting. The recipient may,
however, make an election under Section 83(b) of the IRC to pay tax on
the value of the entire grant in the year the award is made in exchange
for the right to claim capital gain treatment on any future gain. An
83(b) election, which must be made within 30 days of the award, requires the recipient

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