Stock Option and Equity Incentive Plans for Startups: What You Need to Know

What is an Employee Stock Option and an Equity Incentive Plan (EIP)?

An employee stock option is a form of equity compensation award granted under an Equity Incentive Plan (EIP) that allows companies to compensate employees and consultants by providing for an opportunity to participate in the growth of the company’s value. A stock option gives an employee the right to purchase stock in the employer’s company at a fixed price (the exercise price, typically the market value of the stock when the option is granted) for a fixed period. That period is defined by two dates: the vesting date(s), which are the dates that the options (or tranches thereof) vest and can be exercised, and the expiration date, the last date that the options can be exercised. The expiration date is usually 10 years from the grant date. The first tranche of the vesting is often triggered based on a one-year “cliff,” which means the employee or consultant must work for the company for at least one year before any options vest. After the cliff, the remaining unvested options typically vest on a periodic basis, such as monthly or quarterly, over two or three years.

Should my Business use Stock Options under an EIP?

Stock options as a form of compensation under an EIP are often used by start-up companies that may have less cash than their more established competitors, although equity incentive is also popular with companies of all sizes, including large public companies. In addition to compensating employees, employee stock options can incentivize employees and promote employee retention. Employee stock options also align the interests of the employees with the success and growth of the company- when the company succeeds, the equity can become more valuable and offer the employees a rewarding upside.

Types of stock option grants:

A company typically issues two types of stock options: incentive stock options (ISOs) or non-qualified stock options (NQSOs).

ISOs are a form of statutory stock options that are only available for employees and are considered more tax favorable as the employee is only taxed upon sale or disposition of the underlying stock, and not upon exercise of the option. If the employee holds the shares for at least 2 years from the ISO grant and at least 1 year from the date of ISO exercise, the employee will incur favorable long-term capital gains tax (rather than ordinary income tax) on the appreciation between the exercise price and the sale price.

NQSOs, which can be granted to employees and non-employees, do not qualify for special favorable tax treatment under the U.S. Internal Revenue Code and are taxed both when the option is exercised and then again when the underlying stock is sold.  An employee or consultant will pay taxes when he, she or it exercises the NQSO, and the spread (from grant to exercise) is considered compensation income and is taxed as ordinary income rates.  The second taxable event is when the shares are sold.  The taxation of this event will turn on the holding period of the underlying shares, and if that period is greater than one year the gain will be subject to long-term capital gains tax rates.  Of note, with NQSOs, when the employee realizes compensation income on exercise of the option, the company will get a tax deduction for the amount of the compensation expense, and for this reason, NQSOs are considered more company favorable.

How can NEXT Help my Business Create an EIP Plan?

NEXT has fixed-fee packages to assist your business create and implement an EIP plan. NEXT can help you navigate which plans are right for you and help you decide which employees to offer an EIP plan. For additional information or to schedule a consultation, please contact NEXT at info@next.law.

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