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Summary of Key Issues in Designing a Stock Option Plan for Private Companies

Types of Stock Options

There are two types of options, which may be granted to eligible individuals, and these types of options are labeled based upon their income tax attributes. The two types are “incentive stock options” and “nonqualified stock options” (a nonqualified stock option is a label for anything that is not a tax-favored incentive stock option).  A stock option plan may be designed to grant one or both types of options.  Typically, most plans provide for the grant of both types of options.

The two basic income tax advantages associated with incentive stock options are (a) no recognition of regular income tax upon the exercise of an option, even if the purchase price of the stock under the option is less than the then current fair market value of the stock being purchased, and (b) treatment of all gain as capital gain rather than ordinary income in the event that the stock acquired upon the exercise of an incentive stock option is held for at least two years from the date of the option’s grant and one year from the date of the option’s exercise.  By contrast, ordinary income is recognized upon the exercise of a nonqualified stock option with respect to shares which may not be reacquired by the Company in the event of the optionholder’s termination of service (i.e., “vested”), and nonqualified stock options do not offer the opportunity for any difference between the fair market value of the stock on the date of vesting/exercise and the exercise price per share to be taxed at lower capital gains rates.

Presence of Parent or Subsidiary Corporations

A corporation may grant stock under a stock option plan to employees of a parent or subsidiary corporation if that corporation or class of corporations is specifically included under the terms of the plan.  Most plans provide for the inclusion of parent and subsidiary corporations.

Size of Share Reserve

A company needs to determine the exact maximum number of shares, which it wishes to grant under the terms of its stock option plan.  The percentage of outstanding shares, which we typically see for private companies initially establishing stock option plans ranges from approximately 15‑25% of the outstanding shares, and not infrequently companies establish a share reserve equal to 30% of the then outstanding shares.

Eligibility to Receive Options

Options may be granted to employees of included corporations, outside directors of those corporations, and consultants and advisors to those corporations.  Service providers other than employees are legally eligible only to receive nonqualified stock options.  Most plans provide for broad eligibility and include all of the categories listed above.

Option Exercise Price

In order to receive the tax advantages for incentive stock options, such options must be granted for at least 100% of the fair market value of the company’s stock on the date of grant. Tax law applies no similar pricing restrictions upon the exercise price for nonqualified stock options.  A special rule applies to optionholders owning more than 10% of the corporation, in which case an incentive stock option must be granted for at least 110% of the fair market value of the company’s common stock on the date of grant.  Most plans simply set forth these parameters rather than being more restrictive.  As a general rule, non-qualified options of public companies are recommended to be granted at not less than 85% of fair market value to satisfy institutional shareholder concerns.  A company planning to go public should consider avoiding the grant of significant discounted options.

Class of Stock

While either preferred or common stock may be granted under a stock option plan, practically every plan grants options to acquire only common stock.

7. Duration of Option

In order to receive the tax advantages for incentive stock options, such options may not be granted with a term longer than 10 years.  Tax law does not apply a maximum term for the duration of nonqualified stock options.  A special rule applies to optionholders owning more than 10% of the corporation, in which case the maximum term for incentive stock options is reduced to 5 years.

A related issue is under what circumstances an option will terminate prior to the expiration of its term.  Most plans provide for expiration of an option only upon the termination of an individual’s service with the corporation.  Typically, individuals have 30-90 days after termination of service within which to exercise their options (and up to 6-12 months in the event that the optionholder’s termination of service is attributable to disability or 12-18 months in the event that the optionholder’s termination of service is attributable to death).  The tax rules require incentive options to be exercised within 3 months of termination, except that one year is permitted following disability, and options may be exercised until expiration in the event of death.

Most plans also provide for the earlier expiration of options in the event of the transfer of control of the ownership of the company.  However, in actual practice, in the context of an acquisition, the acquiring corporation typically assumes outstanding options.  If the acquiring corporation does not assume the options, many plans provide for the automatic acceleration of vesting or lapse of the company’s repurchase rights upon the occurrence of a transfer of control.  If a plan includes such an acceleration provision, the company’s accountants should be requested to confirm that the provision will not jeopardize pooling of interests accounting treatment in the event of a future acquisition of the company if an acquisition is a likely liquidity strategy for the company’s stockholders.  The plan should also address the possibility of adverse tax consequences for optionholders and the company under the “golden parachute tax provisions.

Administration of the Plan

The company needs to decide whether the entire Board of Directors or only a committee of the Board of Directors will make decisions regarding the administration of the stock option plan in particular making the decision as to who will receive option grants.  Most private companies provide that the entire Board of Directors will determine option grants.  However because of securities law restrictions applicable to publicly traded companies, companies preparing to go public will typically amend their option plans to
exclude the ability of outside directors to participate in the plan and also provide that option grants (at least to the company’s officers) will be made by a committee of two or more outside directors.  If the company is anticipating going public in the not too distant future, it may be appropriate to establish this type of split administration of option grants or else provide that all option grants will be made by a committee of the Board of Directors.  Public companies often have separate option plans for non-employee directors which, although not incentive plans, require shareholder approval.

Form of Payment to Purchase Stock

There are four basic forms of payment that stock option plans use to allow optionholders to purchase stock when exercising their options.  These are (a) cash, or cash equivalents such as checks, (b) shares of the company’s stock already owned by the optionholder, (c) proceeds form the immediate sale of stock upon the exercise of an option (which is only available to companies with publicly traded stock as a practical matter), and (d) a promissory note.  Most plans permit the use of all four forms of payment, or a combination of those forms, but in the standard form of option agreement will typically limit the permissible forms of payment to either cash and cash equivalents or previously owned shares of the company’s stock (in the latter case, generally only after the stock is publicly traded so that there are no disputes over the appropriate value of the stock).

Vesting of Options

Most option plans provide for a period of time during which an optionholder must continuously perform services in order to acquire a contractually unrestricted right to purchase stock upon the exercise of an option.  Shares, which are not subject to contractual restrictions in favor of the company, are called “vested” shares.  While the exact features of vesting schedules differ among plans, a typical vesting period is 4 years, with no vesting for the first 6-12 months and vesting in equal monthly increments thereafter over the remainder of the vesting period.

Some companies tie vesting to the achievement of performance goals.  The primary reason that this practice is not more widespread is attributable to the potential adverse financial accounting consequences associated with performance vesting for stock options.  Under current accounting rules, if the vesting restrictions imposed on a stock option disappear with the passage of time and continued service and if the option is granted with an exercise price of at least 100% of the fair market value of the company’s stock on the date of grant, then accountants will routinely not calculate any charge to earnings for financial accounting purposes.  However, in the event that the vesting restrictions on an option are performance-based, then the accountants will wait to calculate any possible charge to earnings for financial accounting purposes until the time that the performance objective has been satisfied, if at all.  As a result, a company has a difficult time managing these charges to its earnings for financial accounting purposes since it cannot determine in advance the fair market value of the company’s stock at the time that a performance objective is achieved.

Many companies avoid these adverse accounting consequences by granting performance-­accelerated options, known as “TARSAPs.”  (The term “TARSAP” stands for Time Accelerated Restricted Stock Award Plan.”)  TARSAPs ultimately vest based on continued service, with acceleration of vesting if specified performance targets are achieved.  Since the accounting profession is still in the process of sorting out which TARSAPs will receive favorable accounting treatment and which will not, we recommend that companies consult with us and their accountants prior to granting performance-accelerated options.

Time At Which An Option May First Be Exercised

A stock option plan may be designed to permit an individual to exercise an option immediately, even if the optionholder would only acquire unvested (or restricted) shares.  Alternatively, an option plan may be

designed to permit optionholders to acquire only vested shares.  It is administratively simpler to permit the exercise of options only as to vested shares, and many stock option plans sponsored by private companies do exactly that.  However, for certain optionholders, the ability to exercise options immediately as to unvested shares may produce some tax advantages, since, for example, the spread on exercise of an incentive stock option is included for purposes of calculating an individual’s alternative minimum tax, and an early exercise typically results in a smaller spread which is potentially subject to this tax.

Company’s Right of First Refusal

A company designing a stock option plan needs to decide whether or not it will give itself the right to reacquire shares owned by an optionholder which the optionholder wishes to transfer at a time when the company’s stock is not publicly traded.  Most companies do provide for a right of first refusal in favor of the company in that instance, usually in the company’s Bylaws rather than in the stock option plan.

Presence of Vested Share Repurchase Option

A company that wishes to have very tight control over the ownership of its shares while the stock is not publicly traded may retain the right to reacquire even vested shares upon an individual’s termination of service.  Such a repurchase right enables a company to restrict ownership of its shares acquired through its stock option plan only to current service providers.  However, a repurchase provision regarding vested shares does produce an economic disincentive for the optionholder since it makes the option less valuable.  In our experience it is quite rare for emerging growth companies to include such a provision in their plans.

Handling of Leaves of Absence

A company needs to determine how the period of a leave of absence will affect an option. The typical method of handling this situation is not only to provide that the option remain in force during an unpaid leave of absence, but also to award vesting credit for the period of the leave of absence.  However, except for certain employment laws, such generous treatment is not mandated and, given the creation of legally mandated leaves of absence in various circumstances, companies are reassessing whether or not vesting credit will be awarded during the period of a leave of absence to the extent not required by law.

Securities Laws

Before actually granting options, companies should work with qualified legal counsel to ensure that applicable securities law requirements of the states in which the company has optionholders are satisfied. The securities laws of most states do not impose substantive requirements on the terms of compensatory stock option plans.  A few states do have limited substantive requirements, and even more states require advance filings notifying their securities law authorities of the existence and impending use of the option plan.  Most of these laws are simple to satisfy with forethought, and it is more time-consuming and expensive to correct a violation once it has occurred.

Alternative Compensation Awards

Additional types of employee compensation and benefits not addressed in this memorandum include restricted stock (preferred or common), stock appreciation rights (SARs B granted alone or in connection with options), performance units, employment agreements, deferred compensation arrangements, retirement plans, profit sharing plans, life insurance, and other broad-based “cafeteria plan” benefits.  Emerging companies often use options initially to minimize compensation expense and may consider adding other benefits later when stock is more expensive.

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