Lesson #219: Stock Option & Incentive Plans for Startups

I previously wrote about the importance of spreading equity to your employees or key partners. Stock options or other similar incentive plans are a great way to attract talent, incentivize employees and build long term employee loyalty for your business.

Some companies prefer to grant them only to senior management.  But, I am a fan of distributing them through the entire organization, so everyone feels invested in your success together.  Plan to set aside 10-20% of your equity value for your expanded team (e.g., 1-5% for senior execs; 0.5%-1% for middle managers; 0.25-0.5% for entry level staff). This is assuming they are normal salaried employees, and not a co-founder, where equity values could be materially higher (re-read this post on how to split equity between co-founders).

There are typically four types of incentive plans for you to consider, with various rules and tax consequences for the company and the recipients, as summarized below:

1. Non-Qualified Stock Option Plans (The Most Typically Used, Given Advantages Below)

Who Can Receive:  Anyone (e.g., employees, directors, partners)
Waiting Period to Exercise:  No restrictions.  Exercise anytime after they vest.
Exercise Price:  At any price, but taxable to recipient if less than fair market value (FMV)
Transfer Rights:  May or may not be transferable, depending on how you set up the plan.
Term of Options:  Exercisable anytime, provided plan is not set up otherwise.
Value of Underlying Stock:  No limit at time of exercise, provided plan is not set up otherwise.
Taxes to Company:  Deductions allowed from grants, at time recipient recognizes income, provided the company fulfills its withholding obligations.  This ordinary expense is equal to the ordinary income declared by the recipient.
Taxes to Recipient:  No tax at time of grant or exercise.  The recipient receives ordinary income at time of exercise for the difference between sale price and strike price. (So, people don't typically exercise until close to a known liquidity event where they will receive proceeds to cover taxes).

2. Qualified Incentive Stock Option Plans (Not Typically Used, Given Restrictions Below)

Who Can Receive:  Employees Only
Waiting Period to Exercise: One year.
Exercise Price:  At least equal to fair market value (or at least 110% of FMV for 10% holders)
Transfer Rights:  May not be transferred to anyone.
Term of Options:  Exercisable no more than 10 years after grant.
Value of Underlying Stock:  Cannot exceed $100,000 at time of exercise (in one calendar year).
Taxes to Company:  No deductions allowed from grants.
Taxes to Recipient:  No tax at time of grant or exercise.  Capital gain on sale of underlying stock (provided they hold the stock for at least one year after exercise, ordinary income if not).

3. Phantom Stock Option Plans

For some companies, the founders do not want any dilution to their equity.  But, they want to incentivize their employees with the same economic value they would have realized by owning equity.  In this scenario, you would launch what is known as a Phantom Stock Option Plan.  Instead of given rights to purchase stock, you are giving rights to receive the same economic value they would have made by owning the stock, without actually owning the stock.  These cash payouts are typically tied to a liquidity event or exit for the company. For tax purposes, phantom stock is treated the same as deferred cash compensation. Phantom stock payouts are taxable to the employee as ordinary income and tax deductible to the company.

4. Profit Sharing Plans

Another way to accomplish the same incentive, is to establish a profit sharing plan for the company.  So, instead of splitting up the equity and ownership of the business, you simply split up any profits that are generated each year.  The benefit to the individual is getting more control (easier to influence driving profits, than sale of company), in a more timely fashion (paid out annually, instead of at unknown time of sale of the company).  The problem with this route is early-stage businesses should not be distributing cash to its employees, it should be reinvesting that cash into accelerating the company's growth during its early-stage years.  So, if you plan on being a heavy cash user for growth, I would avoid this route.

Vesting, Acceleration & Other Key Terms

In all of the above cases, it is important you put a vesting schedule in place for the recipients before they are able to exercise their options.  Most vesting schedules are set over a four year period of time, to create long term hooks for retaining employees.  Typically, 25% vests per year, where it is a cliff vest in the first year (you have to wait all 12 months before first 25% is earned).  That ensures if an employee is not working out, you can terminate them without losing any equity.  Then after the first year, 1/36 of the 75% is earned monthly, over years two, three and four.  In the event there is a change in control of the business, you would typically accelerate the vesting to 100% earned, so the recipient can get the value created in the sale.

In addition, you want to make sure the company has a mechanic to buy back the underlying stock at the then fair market value and does not allow the recipients to transfer equity to other third parties outside of the company, without your written approval.  You typically don't want equity in the hands of strangers or "unfriendly" parties.

And, worth mentioning, you don't typically grant stock outright, as you do not want to trigger any immediate compensation tax consequences for the recipient or the company.  And, if you don't want to have the expense of setting up and maintaining a formal stock option plan, there are ways to motivate specific individuals, by granting them individual warrants to purchase stock, often with the same economics and vesting you would see with a stock option plan for many.

Hopefully, you found this high level education useful.  But, these are really complex issues.  So, as always, when setting up your plan, seek the counsel of a good startup lawyer to help you avoid the many known pitfalls (here is a good list of startup lawyers in Chicago).

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