What is an employee stock option incentive plan, and why does my startup need one?

There is a misconception that exists among the startup community that employee stock option incentive plans and agreements are only available to midsize or larger companies.  The truth is that these plans are tools that the most creative startups are using at an increasing rate to incentivize and retain their founders and key employees, usually as a substitute for or supplement to normal income or bonus structures.  In short, utilizing this method of compensation as early as possible is an excellent way for startups to save money and provide a true benefit to their most valuable employees.

How does a plan differ from an agreement, and why do I need both?

An employee stock option plan is a document which gets voted on by the board or controlling members of the startup, giving the company permission to create individual agreements with key employees.  An agreement is the individual contract between the startup and the employee outlining the terms of the grant, such as the vesting schedule and termination provisions.  It is crucial that these plans and agreements be implemented correctly, having been drafted by your attorney and agreed to in writing with your employees.

How are these plans taxed?

A typical plan involves separating 10 to 15 percent of the startup's equity into an option pool which is then utilized by granting stock as an option for employees to purchase at a later “exercise date.”  The exercise date is the day the employee gives notice to the startup that they are putting into effect their right to buy or sell the stock that has vested up until that point.  Setting up the plan is not a taxable event for the issuing company, and the employee is only taxed when they sell (not exercise) the grant at a much later date.  Additionally, the employee is only taxed at a capital gains rate that fluctuates between 0 to 23.8% (15% for most), instead of the average income rate at 10% to 37%.  There is an issue with the employee needing to report what is called an Alternative Minimum Tax, which is the price break between the grant price and the fair market value on the date of exercise, but this is situational and can be easily handled by your CPA.  The end result is that the employee will pay less in taxes thereby making more money than they otherwise would have, depending on the health of the startup

What are some issues to look out for as I put these plans in place?

First and foremost, it is necessary to include a vesting schedule that both makes sense and complies with the applicable state and federal laws.  A vesting schedule controls how the employee will earn their shares over time, so that both parties know when the shares can be exercised at any given time.  The average vesting schedule takes place during a four-year period with a one-year cliff, with the employee gaining access to 1/48th of the shares each month during that period.  If a vesting schedule is not put in place by the company, a court will determine what the appropriate vesting schedule should have been in the event litigation arises out of these plans.

Another area to consider carefully is what happens upon termination of the employee.  Startups often require the vested shares to be exercised by the employee between 30 days to three months after termination, but have been known to deviate substantially from this time frame.  Some startups have even gone to the extreme to state that if the employee is fired for cause, they lose access to all vested and unvested shares, which has been upheld by courts.  Most companies issue these options because they value the work of their key employees and want to incentivize their productivity, and rarely draft provisions to hurt them, but they are important issues to consider, nonetheless.

Takeaways

Startups should actively utilize these types of incentive plans to promote the growth of their company and save their key employees money in the process.  While it may seem like a complicated method of compensation on the outset, an increasing number of attorneys are able to implement these plans at an affordable price for startups.  Given the current state of our economy, your founding team should continue to consider alternative ways to compensate and retain your most valuable employees.  On a final note, similar plans and agreements can be created for non-key employees, independent contractors, and advisors; however, there are different tax implications and legal issues that arise in this context, so consult your attorney to learn more about these differences.