When business owners think of offering their employees equity in the company, a stock option plan often comes to mind.
Stock options can be a great tool for owners to engage their employees and attract and keep talented staff. So let’s discuss what stock options are, and in what scenarios they perform best.
What is a Stock Option?
A stock option is the right given to an employee to buy shares at a future time at a price set today.
If the company has increased in value, the employee will be able to purchase company stock at a significant discount and have a real gain in wealth. If the share value declines, the employee does not lose anything because he or she simply does not exercise the option to buy the stock.
How do they Work?
When creating a stock option plan there are three main design issues: price, vesting and term. Let’s look at all three in more detail.
If you are offering employees the opportunity to purchase shares in the future at a price set today, you need to determine what that price is.
For some companies who already value their company, the price may be the current fair market value (FMV) of the shares.
For privately-held companies, price can be anywhere between zero and FMV. If the price is below FMV there may be tax implications to the employee depending upon the quantum of the discount. It’s always best to check with your advisers before pricing the stock option.
For public companies, tax rules are significantly different and beyond the scope of this blog.
Vesting means that the person has earned a right to be able to exercise the option and buy the shares. Vesting takes place over time, typically a period of 3-5 years. For example, let’s say you offer your key employees 100 shares each, which vest equally over a period of four years. Each year, the employee receives the opportunity to purchase 25 shares.
Some companies may choose to have a larger percentage of the shares vest near the end as a way to improve retention. Using the same example above, a company may choose to have the 100 shares vest 20% over the first three years and 40% in year 4.
Other companies may have shares vest when they hit a specific performance target. For example, when the company increases its revenues by 30%, the shares are vested to the employees. This means the employees can’t buy the shares until revenue has increased by 30%.
Performance vesting can be helpful because the company doesn’t dilute its shares until the revenue and the profitability of the company has increased, making the dilution less significant.
In cases where a company is bringing on senior talent they may offer cliff vesting. In cliff vesting, all of the shares vest immediately and the employee can trigger the options at any time.
A term outlines how long the employee has the option to buy the shares. Typically a term ranges anywhere from five to 10 years. If the employee doesn’t exercise the right to trigger the options during this time, they lose the option to purchase the shares.
Where do Stock Options Perform Best?
Stock options are typically used for key people within an organization.
By Camille Jensen