ESOP

What are Stock Options?

Unlisted
August 29, 2022

What are Stock Options?

Stock Options are one of the most common Employee Stock Ownership Plans to incentivise employees.

A stock option is a right (and no obligation) to purchase a set number of shares in the company in the future for a pre-determined price.

Stock Options are often used in companies as an alternative to Restricted Stock Awards (RSA). Especially if the valuation of the company is at a level where shares can not been purchased at a favourable low price. This often occurs after taking on external investments.

How does Stock Options Work? 🧐

Once an employee is granted a Stock Option, the employee must decide whether to accept or decline the Stock Option grant.

The grant is typically given free of charge. This then gives the employee a right to purchase a set amount of shares for a predetermined price a point in time in the future. This period is called the vesting period.

There are two main types of vesting; time-based vesting or performance / conditional based vesting. The most common type of vesting in early stage companies are time-based vesting.

It is also normal that the stock options gradually vest during the vesting period. As the stock options are vested, the employee can choose whether or not to exercise the vested stock options (convert option to shares) and pay the exercise price, also often called strike price.

If the employee were to leave the company before the full vesting period, the employee loose the unvested stock options. In that case, there is usually also a post termination exercise clause which states how long time the employee has to decide whether he/she wants to exercise the vested stock options into shares. This exercise period typically varies based on the termination cause.

Let´s illustrate this with an example: If an employee is granted stock options with a vesting period of 4 years with gradual vesting every quarter, the employee have to work 4 years to earn the right to exercise all stock options into shares. After one year, he/she has earned the right to exercise 1/4 of the granted stock options.

Release schedule

If the employee continue to work with the company, he/she can wait to exercise the options into stock until the expiration date. This is typically set to 10 years after the grant date.

Stock Options are considered risk free as the employer do not have to invest capital upfront. If the share price is lower than the exercise price (often referred to as stock option under water) at the time of exercise, it does not make sense to exercise and hence realise the “loss”.

We will cover typical stock option terms and conditions in mode details in another blog post

Stock Options for Startups (which qualifies to certain criterion)🚀

Governments understand the power of incentivising employees and the importance of the economy to foster innovation and entrepreneurship. Because of this, certain countries have their own stock option scheme for startups. These are different from country to country, so we will not cover all of these for now.

However, Norway also have a scheme for startups that qualify for this. This is very tax efficient for both the option receiver and the company. We will cover all details in a separate blog post

You can also check if your company qualifies for scheme with this questionnaire.

Tax considerations 💵

  • Tax is not applicable at the time of grant. Tax first become applicable when the stock option is exercised.
  • Gains from stock options are in most jurisdictions taxed as income tax. This is unless the stock option qualifies for a special tax scheme. For example the stock options for startups scheme as mentioned above.
  • The applicable income tax is in normal situations typically calculated as the total difference between the fair market price of the time of exercise, minus the cost (total exercise price) the employee paid for the shares.
  • Any additional gain on the shares after time of exercise is in normal situations typically calculated as capital gain tax.
  • For companies only: The received stock option gain is considered a benefit and is hence subject to employer´s tax where applicable (Arbeidsgiveravgift in Norway)
  • (US only: Be aware that there are different tax requirements for Incentive Stock Options (ISO) and Non-qualified Stock Options (NSO))

Advantages with Stock Options 👍

  • No cost: Stock Options are normally granted at no cost.
  • No initial risk: The RSU receiver do not have to pay anything at the date of grant and hence do not bear any initial risk for loss. After exercising the share holder is subject for downside risk.
  • For companies: Less actual shareholders to report to and gather votes from etc.

Disadvantages with Stock Options 👎

  • Shareholder: The stock option holders do not become a shareholder until they exercise
  • The Stock Options has no voting rights
  • The Stock Options are not eligible to dividends
  • Tax: Gains when exercising the stock options are in most jurisdictions taxed as income tax. Hence higher tax rate than capital gain tax.
  • The company is required to pay employer´s tax where applicable (Arbeidsgiveravgift in Norway)
  • Cash squeeze: When stock options are exercise, the receiver has to pay income tax unless they are entitled to a favourable tax scheme, for example the one mentioned above. If the shares are not liquid (easily sellable) at the time of vesting, the receiver might get a big tax claim, which they do not have the money to pay for. This is typically a challenge in private companies.

Administration 📑

Be aware that there are more administration related to Stock Option plans compared to for example a RSA plan. This is related to exercising, payment and related paper work. There are ways to minimise this administration burden. By using best practices coupled with a tailored software, companies can save a lot of time here. Talk to an expert in Unlisted if you want to learn how.

Was this helpful and do you want more?

We hope you found this helpful🦸 We would love to get your feedback on this. Please send any feedback or questions to us at hello@unlisted.ai

And if you do want to learn how we can help you implement and administrate Employee Stock Ownership Plans (ESOP) in your teams, feel free to book a free call with us!

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