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Understanding Stock Options for High-Tech Employment

By Jay Hollander

Jay Hollander, Esq. is the principal of Hollander and Company LLC, www.hollanderco.com, a New York City law firm concentrating its efforts in the protection and development of property interests relating to real property, intellectual property and commercial interests, as well as related litigation.

The content of this article is intended to provide general information relating to its subject matter. Providing it does not establish any attorney-client relationship and does not constitute legal advice. Personal advice in the context of a mutually agreed attorney-client relationship should be sought about your specific circumstances.

Summary: At one time in the early days of the Internet economic boom, stock options were considered the ultimate path to riches. Options can still be an important part of an employment package at a high-tech company, but they're no guarantee of financial riches. This article explains the confusing language and structure of stock options and how to decide how valuable they may be.


Introduction

Up until this past spring, you couldn't read a paper, walk down the street or watch television without hearing about the latest millionaire, rising from nowhere to the top of the heap through the magic of stock options. So tantalizing had they become, especially in pre-IPO technology or dot-com companies, that professionals and others in traditionally high-paying professions like law, jumped ship to work for start-ups, and employees in what had become a very tight labor market started asking for stock options before considering accepting offers from a particular employer. Even Congress has been considering bills to extend tax-friendly stock option plans to larger and larger percentages of company workforces.

Then, March and April came and the market valuations of technology companies fell off the proverbial cliff, plunging the value of many of these stock options "under water," that is, to a level below the supposedly favorable price where employees had the right to buy them. In July of this year, the president of Amazon.com quit to join another company, leaving a substantial amount of such underwater stock options in his wake. Other companies had to consider -- or take -- drastic steps to stem the tide of disenchanted employees from returning to the traditional workforce where they were paid 100% in cash, with no risk.More recently, with some fits and starts, the IPO market for technology companies has selectively rebounded, once again fueling appreciation of, and demand for, favorable stock options. In a topsy-turvy market, just how do you figure out whether to demand or accept stock options as part of your compensation? In a time of substantial market volatility, how do you measure the value of these options? And what will you do with them when and if you get them?These are complicated questions with volumes of books written about them. Tax attorneys and financial advisors make good parts of their living figuring them out and advising clients about them. Still, there are basics to stock options that we'll discuss here, and, when we're through, you'll know enough to ask intelligent questions of your advisors, understand their answers, and be better able to negotiate, whether you're an employer or employee.

Types of Stock Options

The most basic part of the basics is understanding what a stock option is and what kinds there are. Simply, stock options give an employee the chance to participate in the hoped-for appreciation of a company's stock by being granted a right to purchase a predefined number of shares of that stock for a set period of time at a certain price, known as the "exercise" or "strike" price. Options are given to inspire company loyalty and better job performance and, as a result, there is usually a minimum period of employment required for your rights in all or part of the options to vest, that is, for you to be entitled to exercise all or some of your options.There are two kinds of stock options, the main difference between them being their tax consequences to the employer and employee. Options are either "non-qualified" options or "incentive" options.Non-qualified options are often given to employees below key management. Although the eventual anticipated difference or "spread " between the strike price and its fair-market value may make it worthwhile, employees given such "NSO's" pay through the nose in taxes and often must pay cash or significant fees upfront to take advantage of them.After their vesting period is over, employees who exercise their "NSOs" are taxed twice. First, they are taxed on the spread in the year of exercise, even if they don't sell the stock when they exercise the options. Because the spread value is considered compensation, it is taxed at ordinary income tax rates, instead of the lower capital gains rates. At the same time, such employees often have to come up with the cash to buy the stock at the exercise price and pay the taxes on it, or borrow enough to do so. Under the tax rules, the employer gets a tax deduction for the amount considered income to the employee in the year of the exercise. The availability of this deduction to the employer is one reason why employers often prefer "NSOs."Ultimately, assuming the employee holds the stock for a year, a long-term capital gains tax will be due when the employee sells the stock.By comparison, incentive stock options are thought to be more favorable from an employee's point of view because, unlike the case with NSO's, employees pay no tax on "ISO's" until they are actually sold. And when they are sold, they will likely be eligible for low capital gains tax treatment, because of government rules regarding how long they must be held to qualify as incentive options.Here's how they work. There are no magic words needed for an option to qualify as an "incentive" stock option. Instead, there are four main requirements to satisfy. First, the option must be granted to an actual employee. Second, it must be priced at or above the fair-market value of the stock on the date the options are granted. Third, the option term cannot last more than 10 years. Finally, only $100,000 worth of such options can be exercised annually. If the options don't meet the requirements, they will be automatically considered NSO's, no matter what the documentation calls them.If the employee holds the incentive options for two years after their grant before exercise, and holds the stock for another year before sale, he or she will qualify for a long-term capital gains rate on the profit. In this case, however, the employer receives no tax deduction, as it does upon the exercise of NSOs.But, all is not rosy with "ISOs" either, since the ultimate exercise of the stock triggers "alternative minimum tax" analysis. The AMT is basically a parallel method of calculating tax liability that characterizes the ISO stock sale gain as a positive adjustment to your income in the year of sale. Your tax is figured both ways and the higher result becomes the actual tax.As you might guess, there are strategies for reducing or eliminating exposure to the AMT and close consultation with a tax advisor is recommended for all those for whom it is an issue.

Balance of Risk versus Reward

Assuming one can get past the tax issues, there are still more basic considerations affecting the value of stock options, having to do with the strength of the company, timing of exercise and sale, an employee's tolerance for risk and ability to trade lower cash compensation in the short term for the possibility of a big pay day later.Especially in start up companies, employers love stock options since salaries are greatly reduced in exchange for the potential gain they represent and valued employees are held onto for a longer period. Employees have also wanted them, at least until this past spring, because of the chance for sudden riches.Depending on the economic climate, though, hoped-for IPOs can be postponed or shelved indefinitely. Even if there is an IPO, any early run-ups in the stock may not last and are vulnerable to shifts in investor sentiment or economic slowdowns.By contrast, getting options in a company that's already 'public mitigates some of the employee's risks, at the possible cost of slower and less meteoric stock price appreciation and still gives employers a carrot to lure employees.

Valuation and Dilution

Another big problem has to do with valuation. Since every share of stock represents a percentage of ownership in the company, the number of shares and value of the company's stock 'ultimately translates into the value and offered strike price of options. The difficulty, especially in pre-IPO technology start-ups, is that valuation can be more of an argument than a demonstrable fact. Anyone who's ever sought venture capital knows that investors have very different ideas of a company's valuation than do the founders. Before Internet mania, when companies had revenues and earnings, these numbers could be compared to public companies with similar results for a comfortably close estimate of valuation. But where start-ups lack revenues and/or earnings, there aren't always ready comparisons.There is also the question of percentage of ownership and dilution. While the amount of outstanding and issued shares in a public company can be determined, privately held companies don't always part with this information as easily. In contrast to salary compensation, stock options are subject to dilution or watering down of their value as a result of many common types of corporate activities. For example, stock splits, mergers, issuance of additional shares of company stock or warrants or convertible securities all work to potentially severely reduce the percentage of the employee's stake in the company, as represented by the options.Luckily for employers, and unluckily for employees, these activities are generally legal, and employees' only real protections are whatever anti-dilution provisions they can negotiate in their particular option agreement or those that may be contained in the company's employee stock option plan. In start-ups, the founders get the most options and lowest strike prices. This is understandable since they take the most risk. Other top management and key personnel get another chunk, and it is common to leave at least half of the outstanding stock available for investors. This can, and often does, leave employees with very small pieces of the pie, pieces that are possibly further jeopardized by dilutive events.So, if you are an employee deciding on whether to accept a position where a big part of the payoff is in stock options, how do you know whether your "favorable" strike price is really so favorable? How do you even know if the deal you're offered compares favorably with those given to other employees of the company?If you're in a public company, it's relatively easier since a lot of such information is filed with the Securities and Exchange Commission and is available on the Internet. If the company is private, it's much harder and it is largely up to the employee's perseverance -- and management's willingness to divulge this kind of information.

Vesting, Lock-Up Expirations and More

As if there weren't enough headaches already, options are also subject to the uncertainties of vesting schedules and lock-up period expirations. Vesting, as explained earlier, refers to the time that an employee must remain with the company before he or she is entitled to exercise all or some of their options. Lock-up periods, on the other hand, are usually creatures of IPO's and prevent certain employees from selling their stock until a certain date after a company's public offering.If all employees' vesting periods expire around the same time, or if the expiration of both the vesting and lock-up periods come at the same time, the potential for a severely depressed stock price increases dramatically, since there would be a huge influx of selling in the company's stock, all at the same time. Here, too, getting as much information as possible, in advance, can only help in the decision-making process.Of course, there are a host of other risks affecting options, coming not from the company, but from the general marketplace. A new or improved competitor, loss of market share, deteriorating economic conditions and plain-old investor psychology can wreak havoc with the price of a stock and, in turn, the value of stock options.

The full gamut of possibilities and strategies are much larger than can be addressed here, but the subjects highlighted in this article are among the fundamental issues that employers and employees must consider to protect their positions in offering or accepting stock options. It is a truly complicated area where expert advice is highly recommended.

Copyright © Jay Hollander, 2007. All Rights Reserved.

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