How do stock options work for a private company
Nice and simple. And, it often does work exactly this way. Stock options are often referred to as "Incentive Stock Options" by regulators such as stock exchanges, and they are viewed as a means for providing bonus income to employees. They are not - as many of us would like to have it - a way for employees to invest in their company. Indeed, this can be extremely dangerous. Here's a real example - many technology entrepreneurs got caught in exactly this situation.
Size of the option pool
Just to be sure, I checked with the good folks at Deloitte and Touche and they confirmed that this situation can, and does, occur often! Poor Jim! That doesn't help him because he has no other capital gains. He is bankrupt! So much for motivating him with incentive stock options! Under the tax rules, the important point to remember is that a tax liability is assessed at the time when an option is exercised, not when the stock is actually sold.
In the USA, the benefit is taxed as a capital gain if the shares are held for one year prior to sale! Let's go back to the example of Jill buying Multiactive stock. Up until recently, she would actually have to pay the tax in cash. Nice, eh?
Stock Options in Privately Held Companies
Worried that she might have no profit, she sells. Not good. But true! She still gets no relief on her original tax bill. I wonder what happens if she never sells her shares? Would her tax liability be deferred forever? Again, this is OK. Because of the potential negative impact brought about by acquiring and holding shares, most employees are effectively forced into selling the shares immediately - i. But, can you imagine the impact on a venture company's share price when five or six optionees "dump" hundreds of thousands of shares into the market?
This does nothing to encourage employees to hold company shares. And it can mess up the market for a thinly traded security. From an investor's perspective, there's a huge downside to options, namely dilution. This is significant. From the company's perspective, the routine granting and subsequent exercising of options can quickly compound the outstanding share balance.
This gives rise to " market capitalization creep " - a steady rise in value of the company attributable to an increased stock float. Employees are either awarded stock or get the right to buy a certain number of shares at a certain price for a certain period of time.
The Downside Risk
Companies can choose from several different award types based on their equity compensation goals and objectives. Here are four of the most common awards:.
There are many reasons companies decide to offer equity compensation plans, but the primary motivators are: compensation, retention and hiring. Offering equity compensation can be especially valuable for small companies and startups because it offers employees a potential return in addition to their salaries. Retention — Most stock options come with vesting requirements, which means employees have to stay with a company to experience the full benefit of their equity compensation awards.
This is why companies often find equity compensation to be a powerful tool for retaining good employees and motivating them to help increase the value of the business.
It can also help attract people with an entrepreneurial mindset who are interested in making an impact and growing the company. Many private companies have implemented effective equity compensation plans by ensuring the plans work for both their company and their employees. Here are five key steps they often follow:.
Creating a reserve pool — Here are some of the key things companies may consider at this stage:. Approving the plan — The equity compensation plan and pool typically require board approval. Creating grant agreements — Companies consider where their employees are located and what global tax implications there will be if they offer them stock in the company.
Business Basics - Stock Options (Incentive)
Global tax rules and regulations are complex and may require plan addendums for different countries. Managing the plan efficiently — Once a company has established the plan with the help of their law firm, companies decide how they will manage the day to day tasks of a plan. This may include updating the cap table, exercising and processing grant agreements, terminations and calculating expenses for stock options issued.
While some companies leave these tasks to their law firm, others may find this too expensive and may opt to manage these tasks on their own. They continue to consult with their law firm on the plan while choosing to manage day to day tasks internally. In the beginning, some companies decide to manage their equity compensation plans on spreadsheets. But many find that the company outgrows that option very quickly once the business gets bigger and or expands globally.
For this reason, many companies choose an equity compensation platform like Shareworks by Morgan Stanley to grow with them. Shareworks platform editions support private companies in all stages of growth. Shareworks by Morgan Stanley has helped thousands of companies with the administration of their stock option and equity compensation plans. Our clients include startups, emerging companies and global public companies, such as Uber, Dropbox and Atlassian. We welcome the opportunity to show you how Shareworks can help you solve your equity plan management challenges.
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