Why Does a Company Issue Stock Options?

Written by Dan DeWolf

One of the critical keys to a successful venture is aligning the interests of the employees and management with the interests of the shareholders/investors. After all, perhaps the greatest asset of a company is its people. Without a competent and motivated workforce, a venture is unlikely to succeed no matter how great an idea or business concept is involved.

One way to align the interests of the employees with the investors is to create a culture of ownership. Many start-up enterprises have limited capital and need to conserve their capital spending until they become cash-flow positive from operations. Accordingly, most start-ups are not able to pay wages that are equivalent to large, legacy companies. Further, since many start-ups may not succeed, taking a job with a start-up enterprise is more risky than taking a job with an established company. So why would anyone take a job with a start-up enterprise? The answer is equity! By joining a start-up an employee has the opportunity to obtain an equity stake at a low valuation in the enterprise with the hope that one day that equity stake will be worth a significant amount. By granting equity rights to the employees, the employees are no longer just workers — they are also owners. When you are an owner, your work is not "just a job," and you are more willing to take on responsibility and take pride in your work-product.

The most typical way of granting employees an equity ownership in a company is by the issuance of stock options. A stock option gives an employee the right to buy a fixed number of shares in a company at a fixed price over a certain period of time. 

There are two types of stock options granted to employees: Incentive Stock Options ("ISOs") and Non-Incentive Stock Options ("NISOs or "Non-Qualified Options"). Historically, ISOs were created to provide a tax-efficient way of granting equity to employees. The operative provisions relating to ISOs is Section 422 of the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"). A Non-Qualified Option is any option that does not fit within the specific criteria of an ISO spelled out in Section 422 of the Internal Revenue Code.

The tax advantage of an ISO is that there is not tax on the date of grant of the option and there is not tax on the date of exercise. That said, the tax benefits attributable to ISOs may in fact be somewhat illusory. Although there is no tax on the date of exercise, the amount of gain between the exercise price and the fair market value will be considered for AMT (alternative minimum tax) purposes by the IRS. Thus, an employee who exercises his option may have to pay taxes under the AMT provisions, even though he or she may not have realized any cash yet from his or her options if he or she has not in turn sold the stock received upon exercise of the options. Secondly, in order to obtain long-term capital gains treatments on the options, the employee must hold the stock received upon exercise of the option for at least one year before selling. As such, the employee will have to bear the market risk that the stock price may go down below the exercise price of the stock options before he or she sells his stock. This set of circumstances may result in the employee actually losing money on the options! Because most employees do not wish to take the market risk that the stock received will go down in value, most employees exercise the options and sell the underlying shares on the same day. The result of this is that the employee receives short-term capital gains treatment on the sale of the stock, which is the same taxable rate as ordinary income. Since the ordinary tax rates are significantly higher than long-term capital gains rate, the purported tax benefit of obtaining ISOs is often nonexistent.

One of the most vexing problems for companies (and their board of directors) is determining the fair market value of its Common Stock for purposes of calculating the exercise price. In a public company, determining the fair market price of stock is made quite easy by looking at the closing price on the company's stock as quoted on the appropriate exchange or electronic market. For private companies, the task is not so simple. Stock options are generally granted for shares of Common Stock. The shares purchased by a venture capital firm are for Preferred Stock. By the terms of the Preferred Stock, it is senior in liquidation and in dividends to the Common Stock. Because the Preferred Stock is senior in terms of liquidation and in dividends, the Common Stock is less valuable than the Preferred Stock. In many instances, upon a liquidation or sale of a company, the preferences of the Preferred Stock may use up all or nearly all of the proceeds leaving very little consideration attributable to the Common Stock. Thus, in many early-stage companies, the fair market price per share of the Common Stock should be at a significant discount to the price per share of the Preferred Stock. The employees would like the board to determine the discount to be as great as possible, and it is not atypical for early-stage companies to have stock options priced at a 90% discount to the price of the Preferred Stock. As the company matures, however, the difference in value between the Preferred Stock and the Common Stock should narrow, as there should be sufficient proceeds attributable to the Common Stock for the holders to be made whole as the company hopefully accretes in value. Further, if the company is nearing an initial public offering, where all the Preferred Stock will have to convert to Common Stock when the company goes public, there should be relatively no difference in fair market value between the price of the Preferred Stock and the price of the Common Stock. The problem for the board of directors is how to make these valuation decisions and when. To further complicate the situation, Regulation 409A of the Internal Revenue Code, places an excise tax on the employees if the valuation is too low and cannot be substantiated. Generally, the board will engage an independent valuation expert to provide what is now commonly known as a “409 Valuation.”

One of the key issues for boards of directors to consider when issuing stock options is the vesting schedule. Vesting refers to the timing during which an employee can exercise his or her options. What the company wants to set up is the business dynamic whereby the employee feels he or she needs to remain with the company in order to obtain significant economic upside. Sometimes this is referred to as a "golden handcuff." What a company does not want to do is grant a large equity stake to an employee on Day One and see that employee leave for another opportunity but continue to own a large equity stake in the company. Accordingly, smartly managed companies set up vesting schedules for options so that the employee must stay some set minimum period of time before any options vest and are exercisable. Typically, options will be fully vested over three to five years.

Many companies set up something called "cliff vesting." What that means is that options do not vest for a period of time — say one year — but after that point in time, the entire year's worth of options will vest. After the initial cliff period, the remaining options will continue to vest regularly on either a monthly or quarterly schedule.