Offering employees co-ownership or a piece of the company can be complicated-and risky-undertaking.
As an alternative to increasing cash compensation, many employers are choosing to offer stock options to attract and retain talent. The underlying co-ownerhsip rationale is two-fold.
- First, this type of compensation does not require an employer to part with additional cash, which often is in short supply during a company’s early years.
- Second, these types of plans afford employees with strong financial incentives to perform at a high level and remain with the company.
There are a variety of equity based co-ownership compensation plans, all with advantages and disadvantages. The following is a broad overview of some of the more common plans.
Incentive stock options (lSO) afford option holders with preferential income tax treatment. In general, gains realized when the stock is sold are taxed as long-term capital gains.
ISOs may be granted only to employees and must satisfy certain requirements.
To begin with, the employee cannot sell the stock received upon exercise of the option for two years after the option is granted, or within one year of exercising the option. Also, the option may only be exercised while the person is an employee or within three months of leaving the company, (Special rules apply for terminations due to disability or death.)
Non-qualified stock options (NQSO), on the other hand, are more flexible. The exercise price can be set at less than fair market value on the date they are granted, there are no dollar limits on the amount of shares that may be acquired through the exercise of an NQSO in any one year (whereas an ISO has a $100,000 limit), and NQSOs may be granted to non-employee directors and certain non-employee consultants.
Restricted stock awards are grants of shares of a company’s common stock. Except for the risk of forfeiture, the shares generally confer the rights of other shares of common stock, including economic ownership, the right to vote, and in most but not all cases the right to receive dividends.
Shares of restricted stock are subject to restrictions until the shares “vest”.
Vesting usually depends on both the passage of time and continued employment with the company. In addition, some companies impose performance-based standards that must be achieved before the restrictions lapse.
Once restrictions do lapse and shares are fully vested, they are no longer restricted stock and are treated as other shares of the company’s outstanding common stock.
Regardless of which co-ownership compensation plan a company decides to pursue, the options, underlying shares, and restricted stock are securities. As such, they must be registered under federal and state securities laws or structured pursuant to applicable exemptions under such laws. Under these securities laws, a non-public company can inadvertently become subject, to the Securities Exchange Act and forced to register and file periodic reports if it meets certain
In addition, once employees own a minority interest in the company, the controlling shareholders will have to worry about fiduciary duties to minority shareholders, creating potential conflicts of interest. Small companies also should consider implementing a right to repurchase securities upon termination, when allowed, to avoid the complications that arise when former employees own shares.
In light of the variations in employee compensation plans and the numerous traps they may present if not structured properly, companies should seek the advice of legal counsel prior to embarking on any such venture.