Giving Away The Company: Employee Stock Options And Repricing Considerations

Start-up companies are receiving increasing demands from employees, financing companies and professional service providers to issue stock options as a prerequisite to their employment or business relationship. With the recent downturn in the stock market, these companies now face increasing pressure from employees to reprice existing stock options with stiff resistence from non-employee shareholders.

Legal Considerations in Equity-based Compensation Plans

The use of stock options is no longer limited to large corporations providing incentives to senior management. High- growth companies provide stock options to all levels of employees, consultants and independent contractors. Stock options provide employees with the chance to participate in company growth, a public offering or sale of the company. For the employee, this opportunity may justify accepting lower pay and greater risk. For company founders, the dilution in ownership may be offset by the chance to attract and retain top-quality employees.

While the basic concept of stock options is easy to understand, implementing a stock option plan can be quite complex. It requires careful attention to tax, securities and employment law requirements, as well as an understanding of the financial reporting impact to the company.

Statutory Stock Options

Statutory stock options are given special tax treatment under the Internal Revenue Code. The most common type of qualified option is the incentive stock option (or “ISO”). To qualify as ISOs, options must have special characteristics, including the following: (a) they may be issued only to employees (not independent contractors), who must exercise them within certain time limits; (b) the exercise price must be at least equal to the stock’s market price; and (c) the employee cannot sell the stock earlier than (i) two years after option grant and (ii) one year after option is exercised.

The advantage of an ISO is that the employee will not be taxed upon issuance or exercise of the option, but instead can postpone taxation until the stock received is later sold. ISOs are somewhat disadvantageous to the employer because no tax deduction is allowed for the stock issued to the employee.

However, many employers in the early stages do not need tax deductions, and the benefits to employee motivation normally exceed the detriment of the lost tax deduction. The exercise of an ISO may also trigger an alternative minimum tax obligation for the employee that can be staggering in size and create substantial hardship especially if the stock’s value subsequently declines.

Non-Statutory Stock Options

Non-statutory stock options (or “NSOs”) are not given special tax treatment under the Internal Revenue Code. The employee is not taxed when the option is issued, but instead is taxed when the option is exercised. The employer receives a tax deduction at that time. The employee cannot make an 83(b) election to convert the NSO’s ordinary income to capital gains. NSOs provide flexibility because they are not subject to the various caps and limitations imposed on ISOs.

Restricted Stock

Restricted stock includes stock purchased directly from the employer or received as a result of exercising an option where full ownership of the stock is subject to vesting restrictions (e.g., continued employment). The employee will be taxed on the difference between the purchase price and the stock’s market price at the time the stock is issued (the difference should be small or non-existent). If the employee elects to “lock in” tax consequences at the time the restricted stock is issued, no additional tax will be imposed as the stock vests and the repurchase restriction lapses. The objective of the election is to convert the future appreciation in the stock from ordinary income to long-term capital gain. This “83(b)” election can offer tremendous planning opportunities but can also have substantial disadvantages if the value of the stock subsequently declines.

Other Plans

Stock Appreciation Rights (“SARS”) give an employee the contractual right to receive cash or stock in an amount equal to the appreciation in a specified number of the employer’s shares over time. SARS can be combined with options and other compensation arrangements. The employee is taxed upon the receipt of cash or unrestricted stock, and the employer is allowed a deduction at that time.

A Phantom Stock Plan gives the employee the right to receive a bonus based on the performance of the employer’s stock. The employee need not actually own or have any right to the employer’s stock. The amount of the bonus is typically equal to the difference between fair market value of the employer’s stock at the date of the grant and fair market value at a later specified date. These plans are similar to SARS, but the employer establishes the specific date of exercise. The right to receive a bonus typically is contingent upon continued employment through the date of exercise. The bonus may be paid in cash, stock, promissory notes or other consideration. The employee does not recognize income when the phantom shares are granted, but must recognize ordinary income upon receipt of the cash bonus. The employee is taxed at ordinary income tax rates, and the employer receives a tax deduction at the same time.

Many employers prefer to offer SARS and Phantom Stock as equity-based incentives because the employee receives no ownership interest in the employer’s stock (and therefore no voting, dividend, or corporate record inspection rights). As with all compensation programs other than ISOs, the employer must be careful to withhold applicable income and employment taxes.

Securities Issues

Once a company decides upon the type of equity plan to offer its employees, it must make sure the plan complies with federal and state securities laws. Private companies will want their plans to be exempt from registration under the securities law. Registering a securities offering can be very expensive, and the failure to do so can lead to serious financial, legal and regulatory problems, including potential personal liability.

Federal and California state laws require the offer and the sale of a security (including the grant and exercise of an option) to be registered with the Securities and Exchange Commission and the Department of Corporations, unless an exemption to registration applies. Both federal and California laws provide an exemption for equity-based compensation security offerings if certain conditions are met. The most basic requirements in receiving an exemption are the existence of a written plan and the distribution of the plan to all eligible participants.

Federal regulations also put a cap on the total value of the equity-based compensation that qualifies for the exemption. In particular, the value of the securities offered during any consecutive twelve-month period cannot exceed the greatest of (1) $1,000,000, (2) 15% of the total assets of the issuer, or (3) 15% of the outstanding amount of the class of securities being offered and sold.

California law further requires option plans to describe the number of shares that may be issued, the persons eligible to receive the shares, the minimum exercise price for the shares, the period during which the options may be exercised, certain mandatory restrictions on the transfer of the shares, the plan termination date, and specific periods for exercising the options under the plan.

Employment Issues

A critical issue for equity-based compensation plans is how the compensation is classified for employment law purposes. In 1999, the Department of Labor determined that under the Fair Labor Standards Act of 1938 (the “FLSA”) any profit realized by an employee from stock options must be taken into consideration when determining an employee’s regular rate of pay. This determination caught the attention of employers using stock options because overtime pay is based on one and a half times the employee’s regular pay rate. In response to and after a considerable outcry from employers, the Worker Economic Opportunity Act was passed and signed into law on May 18, 2000. This Act amends the FLSA to provide that compensation from equity-based compensation plans is not to be included in the calculation of an employee’s regular rate of pay if (1) the compensation is paid pursuant to a plan, (2) there is a six-month waiting period before exercising a stock option, (3) the exercise price is at least 85% of the stock’s fair market value, (4) the exercise of any grant or right is voluntary, and (5) the determination to award options is based on previously established performance-based criteria.

Repricing Stock Options

The recent downturn in the stock market has caused a substantial reduction in the intrinsic value of many employee stock options. The decrease in the spread between the stock’s market value and the option’s exercise price has caused many options to have little or no value. Management often seeks a reduction in the option exercise price to reignite employee incentive, and provide the appropriate compensation mix. Option repricing allows employees to “recapture” a portion of the company’s ownership that was lost when the stock price sagged. Non-employee shareholders are increasingly rebuffing option repricing, because their stock value also decreased and option repricing is viewed as providing a safety-net for employee option holders while further cutting into the shareholders’ ownership interests.

The repricing of an ISO plan is considered a new option grant that must be completely retested under the ISO rules. From an accounting perspective, repricing may result in a charge to earnings if it results in a variable option plan, and may preclude pooling of interest accounting in a subsequent business combination.

All of these business issues must be considered and weighed before any action is taken. Aggressive repricing may dilute shareholder value, violate funding agreements and lessen the availability of future company financing; but failure to reprice an option may lead to employee attrition.