This is the third article in a series examining when an entrepreneur should consider granting equity or equity-like interests in his or her company, and if so, how to properly structure that equity or equity-like grant.  To view the first article in this series, please click here.  To view the second article in this series, please click here.  Today’s topic: Stock Option Plans and Agreements.

Before beginning, I would like to preface this article with a high level view on stock options as they related to fitness companies.  Most of the time, stock options do not make sense for club fitness or studio fitness concepts. Generally, but not always, stock options are commonly used in fast growth companies where there will be an exit event (IPO or sale).  Typically, club and studio concepts are not applying a “high growth then exit” model.  However, stock options may be an excellent fit for those companies at the intersection of fitness and technology, where an exit strategy is talked about from day one of incorporation.  Stock options can add a considerable amount of complexity to the tax and legal aspects of your business.  Therefore, be sure to meet with both accountants and attorneys well-versed in the language of stock options before getting too far down the road with this concept.

Background

As mentioned above, stock options are complicated.  To begin with, when you grant stock options to a person, you are not granting them actual equity or stock in your company, but instead you are granting them a right to buy stock in the future upon specified events at a specific price (aka the exercise price). 

There are two basic types of stock options that are commonly granted to employees: Incentive Stock Options (“ISOs”) and Non-Qualified Stock Options (“NQSOs”).  The primary differences between NQSOs and ISOs lie in their relative flexibility and tax consequences.  Each of ISOs and NQSOs are described immediately below.

Incentive Stock Options

ISOs are subject to a number of statutory requirements, including, but not limited to, the following:

1. ISOs must be issued to current employees.

2. ISOs must be granted pursuant to a plan that states the total number of shares that may be issued to employees eligible to receive the options.

3. The ISO price may not be less than the fair market value of the stock at the time the option is granted.

4. At the time the ISOs are granted, the employee must not own more than 10% of the total combined voting power of all classes of stock of the company.

5. The aggregate fair market value of stock that can be purchased by the employee pursuant to ISOs exercisable for the first time during any calendar year under all plans of the company may not exceed $100,000.  

After exercising ISOs, if the employee later sells the stock received, the employee will usually recognize a capital gain based on the difference between the sales price and the exercise price, assuming the employee has held the stock for at least one year.  This tax savings, when realized, can be material for the employee because of the 20% difference in applicable tax rates (ordinary income approaching 40% tax rates and capital gains at 20% tax rates), and is the primary reason most employees think they want ISOs when granted stock options.  However, the employee may owe tax upon exercise to the extent he or she is subject to the AMT (Alternative Minimum Tax), which would negate some or all of the anticipated tax savings. 

Additionally, ISOs are viewed favorably by employees because he or she typically will not recognize any income when an ISO is exercised.  Conversely, the company receives no tax deduction in connection with the granting or exercise of ISOs, which is another reason companies prefer to issue NQSOs.

Non-Qualified Stock Options

NQSOs are basically any options that are not ISOs, meaning, they do not satisfy the statutory requirements of ISOs.  NQSOs are generally used by private, closely held businesses.    

Unlike ISOs, NQSOs may have a fixed exercise price, a variable exercise price, or an exercise price that has fixed and variable components.  Because NQSOs are not required to meet the stringent fair market requirements applicable to ISOs, the company has the flexibility of setting the exercise price using any of these methods, which may be above, below, or equal to the fair market value of the stock at the time of the grant. 

Typically, but subject in each case to the negotiated agreement between the company and the employee or advisor, NQSOs will be subject to a four year vesting plan with a one year cliff.  This means if the employee leaves or is fired within the first year of employment, no options will be vested and the employee has no corresponding exercise rights.  This is generally done to create an incentive for employees to remain with the company and take a long term view of the company’s success.  Also, if someone leaves within a year, these options could be issued to a new employee that is going to take over for the employee that left.

NQSOs will have tax consequences for the employee at the time of grant if the options have a readily ascertainable fair market value.  If so, the employee will owe ordinary income tax on the difference between the fair market value price of the NQSOs and the exercise price, if any.  Typically, the granting of NQSOs will not have an immediate tax consequence to the employee because the options will not have a readily ascertainable fair market value. 

The company is entitled to a tax deduction when the employee is required to declare ordinary income.  The company is also subject to withholding requirements applicable to employee compensation.  When the employee later sells the stock, the excess of the sales price over the sum of the exercise price and ordinary income previously recognized is taxed at the capital gains rate to the employee.  The company does not receive any tax deduction for this sale event by the employee.

Overall, NQSOs are generally desired by employers due to their flexibility and tax benefits.  They are also desirable because NQSOs can be granted to non-employees (directors or advisors). 

Common Misconceptions by Recipients Regarding their Stock Options 

The following issues often come up when I meet with individuals that have been awarded stock options and are now trying to figure out exactly what they own and what their rights may be.  

1. Voting/Control.  Stock options generally do not include voting rights and will likely have restrictions on access to information.

2. Expiration of Options.  Options usually expire within 30-90 days after the termination of employment. Therefore, if the employee wants to keep any benefit, he or she will need to write a check to the company exercising any vested options (check amount = strike price times number of vested shares to be exercised), with no assurance that the company may ultimately be sold or otherwise have a liquidity event. 

3. Dilution.  Stock options, much like the underlying shares received upon exercise, will likely be diluted by future stock or options issuances.

4. (Generally Not) Accelerated Vesting.  If the company is sold, typically unvested stock options do not receive accelerated vesting.  Therefore, unless an employee or advisor has provided services for four years prior to a liquidity event, (assuming a typical four year vesting period), or has otherwise negotiated and documented accelerated vesting up front, an employee may not receive all of the upside he or she contemplated.

5. “How Much are they Worth?”  Most employees that receive stock options will almost never get rich from the options.  The most relevant information in determining the price of the stock options can often be obtained in the most recent valuation of the company (if available).   If no valuation is available, you should work with an accountant well-versed in start-ups to determine if the options are “in the money.” 

Summary

Stock options – both ISOs and NQSOs – are very complicated and owners of the company should discuss the pro and cons of issuing options with both an attorney and an accountant before proceeding.  In most scenarios, especially with closely-held private businesses, there may be better alternatives that both the owners and the employees or advisors may favor.