Starting a small business comes with many challenges. Among them: How do you attract and incentivize talented executives and employees to join the team? That can be easy…with a LOT of cash or by granting a substantial portion of equity. But what if you want to entice talented workers without the premium salaries and without giving up a huge piece of your business to someone you don’t know well? One option is for small business owners to compensate employees with employee stock options in order to preserve cash and retain quality employees.
What are Employee Stock Options?
Employee stock options, which are typically granted in addition to a moderate salary, give an employee the right (but not obligation) to buy a specified number of shares in the company at a predetermined price (the grant or exercise price). Employee stock options typically have a vesting period, which specifies the date or dates at which the employee is able to exercise his or her right to buy stock. Employee stock options must be exercised before the vesting period expires. Information on the grant, purchase price, vesting period and expiration should be properly detailed in the contract between the employer and the employee.
What are the types of Employee Stock Options?
There are two types of employee stock options: Non-qualified stock options (NSOs) and Incentive Stock Options (ISOs). NSOs can be offered to anyone, but are typically offered to non-executive employees and consultants, while ISOs are only offered to employees and executives. The difference between these two types of employee stock options is found primarily in their treatment for tax purposes. NSOs become taxable at the exercise of the option or sale of shares, but not at the grant, at ordinary income rates. However, ISOs are taxable only at the sale of shares, not the grant or exercise of the option. ISOs can either be immediately taxable at ordinary income levels or taxable as long-term capital gain if the shares of stock are held for twelve months after an employee chooses to exercise his or her option and the employee’s shares are not sold until two years after the grant date.
What’s the upside?
Employee stock options are a good way to attract hardworking employees while preserving cash in the short term that the company can invest back into the business. They also allow the business owner to preserve equity and to grant it to those who have “earned” it over time. Giving employees the option to have a stake in the company can align employee interests with the interests of shareholders and incentivize them to work harder while seeing the value of company stock appreciate. Employees can also determine when to be liable for taxes depending upon which type of employee stock option they are granted. Tax liability can also be determined by filing an 83(b) election and paying taxes on the gift value of their shares when the grant is made instead of when the shares are received (and potentially much more valuable).
What are the Drawbacks?
Offering employee stock options may not be right for every company, especially for small, privately owned businesses that do not want to go public. It can be difficult to create a market for employees to sell their shares, giving employees less of an incentive to buy them in the first place. Since there is no existing market for a small privately owned business, it is difficult for employers to properly value the options. Discounted options can result in heavy tax penalties. The tax and valuation issues may result in the need for a thorough and costly business valuation.
Although employee stock options may appear to be a good way to incentivize employees at first glance, workers will not feel the impact of a decrease in stock value in the same way that a shareholder will because the stock options only give employees the right to buy stock, but buying stock is not required.
Employers also face difficulty in predicting how employment in their small business will grow. Granting too many options too soon can prevent future employees from receiving options. Too many employee stock options can also deter future shareholders from investing in the business due to the number of existing minority shareholders in the company and the potential for that list of minority shareholders to grow.
What’s the bottom line?
Employee stock options can be a great, but complicated, tool for your business. Small business owners should weigh the advantages and potential consequences before deciding to move forward.