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Monday, April 02, 2007

Stock Options 101- for the Entrepreneur

This a subject that can confuse the first time employee, what does the stock options mean to them ? and what are the pitfalls....this information is not meant to be a definitive statement and I would suggest that you talk to your IFA for the legal cut on Stock options. This article was cut for the the USA market, but has a lot off similarities to the UK /Europe, setting up a stock options plan for your company is something you need to plan on taking 3 to 6 months, as you will have to involve the government tax bodies and they work to there own timetable.

Startup Stock Options: ISOs vs. NSOs
Startup Stock Options — Dave Naffziger on March 31, 2007

An Employee’s Guide to Startup Stock OptionsEven seasoned startup personnel frequently misunderstand the ins and outs of their options. I initially thought I could cram a full overview into one post, but quickly realized that it would take several posts to get into the detail that I wanted. So, this is the first post in the Startup Stock Options series. These posts are intended for employees and other people that own startup stock options. Brad Feld has a great series on Term Sheets which cover stock options (and plenty of other issues) that are more geared for company founders.

The first aspect I’ll discuss is the two option types: Incentive Stock Options (ISOs, sometimes called Statutory or Qualified Options) and Nonqualified Stock Options (NSOs, NQSOs or sometimes called Nonquals). Many aspects of stock options are impacted by which type you hold so developing this familiarity early will help discussions later on. I’m not going to address Employee Stock Purchase Programs (ESPPs), as they are inappropriate for and rarely seen at startups. For a super-detailed look at the two option visit this writeup by Johanson & Berenson LLP.
Most option agreements will state which type of option you hold. All ISOs need to be issued under an ISO Agreement, which pretty much ensures that the agreement is named something like “Incentive Stock Option Agreement”. I’ve never seen an ISO Agreement that wasn’t named that way, but I’m not familiar enough with the legal aspects to guarantee this is always the case. The easiest way to find out if you hold ISOs or NSOs is to ask your employer.
Incentive Stock OptionsIncentive Stock Options are a class of options created by the IRS that provide tax advantages over NSOs. These tax advantages are two-fold:
ISOs are taxed on the stock sale (not the grant or exercise). NSOs are taxed on the exercise of the option. You don’t make money until you sell the stock. There can often be gaps between the time you exercise the option (buy the stock), and sell the stock. There are plenty of scenarios where you may exercise the option, but never have the opportunity to sell it. This benefit prevents the worst-case NSO scenario from happening: your unsold, exercised stock becomes worthless. You’ve lost the money you paid to exercise the option, and you would also have to pay the IRS ordinary income taxes on the difference between the exercise price you paid and the market value of the option. So, if you paid $100 to exercise stock worth $1000, you could have to pay the IRS up to 35% of the $900 ‘gain’.
ISO shares may receive long-term capital gain tax treatment. If they have been held long enough to satisfy a special holding period ISO stocks can be taxed at lower long-term capital gains tax rates. Long-term capital gains are currently 15%. Ordinary income tax rates can go up to 35%.
It is also worth noting that the Alternative Minimum Tax is increasingly reducing the tax benefits of ISOs. But more on this in a later post.
There are multiple eligibility requirements for an ISO option. The notable requirements include (but aren’t limited to):
Employees only
Must be granted at fair market value (409A hell for companies)
Non-transferable (except through inheritance)
Must be granted within 10 years of shareholder/board approval
Must be exercised within 10 years of grant
Nonqualified Stock OptionsAny option that does not ‘qualify’ to meet the requirements of an ISO or ESPP is an NSO (hence their nickname: ‘nonqual’). NSOs are far more flexible than ISOs, but several important differences include:
Can be given to anyone (partners, consultants, board members, gas station attendants, etc.)
Can be priced below (or above) current market value
Typically taxed on exercise at ordinary income tax rates. In some instances, they can be taxed at issuance.
ISOs offer tax advantages, but NSOs offer substantial flexibility. Consequently, many startups issue both ISO and NSO options depending on the situation. As an employee, in most cases you would prefer to receive ISO instead of NSO options.



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