Succeeding in Your Business: Expect these questions when you give employees stock options

Cliff Ennico 

“We started a business some time ago and have about 10 employees.

“The business has done well, to the point where we want to give our employees options to acquire stock in our company.

“We had our lawyer draw up a stock option plan and agreements granting options to our employees, but we’re getting hit with tons of questions and don’t know how to answer them. Can you help?”

When you give options to your employees, keep in mind that many, if not most, of them have never seen anything like this before.

Here are the most common questions they will ask, and my best answers.

Does this mean I own stock in the company?

Not yet. Options give employees the right to acquire stock in the company at a future time, for today’s price. Until the employee exercises the options (swaps the options for actual shares), the employee has none of the rights of a shareholder. If the company has a shareholders’ agreement in place, employees should be required to sign onto the agreement when they exercise their options and become shareholders.

What is this $0.00001 “par value?” Is that what I pay for the stock?

Par value has nothing to do with what the employee will pay when exercising his options. Par value is an arbitrary amount used by accountants and lawyers to establish the stated capital of the company. Because some states (such as Delaware) impose taxes on a company’s stated capital, par values are set as low as possible.

The “exercise” or “strike” price is what the employee pays for shares when he/she exercises options.

How did you come up with the exercise (strike) price?

By having an independent appraiser determine the market value of the company, then dividing that value by the number of issued and outstanding shares of stock.

Why must I pay for my shares? Why aren’t they just free?

Because of the tax laws. If a company gives shares to employees for free, the employees are taxed on the full market value of the shares at “ordinary income” rates (see below).

The exercise price cannot be lower than the company's market value per share at the time of grant. Otherwise, the employee receives a taxable bargain.

I’ve been working here for years. Why aren’t some of my options vesting now to reflect my years of service?

Because if they vested now, the employee would be socked with taxes on the full fair market value of the shares he/she received upon exercising the option. Because options are considered compensation, that value would be taxed at very high “ordinary income” rates.

What the heck is a “cashless exercise?” Does that mean I get stock for free?

Cashless exercise is actually a good thing for the employee. If an optionee needs to exercise options (to avoid their expiration, for example), but cannot afford to pay the strike price in cash, electing a cashless exercise enables the employee to receive some (not all) of their options without having to pay a penny for them.

Here’s an example of how it works: Let’s say an employee has 1,000 vested options he/she needs to exercise with a strike price of $7.25 each, at a time when the market price of the company is $10 a share. Without a cashless exercise option, the employee would need to cough up $7,250 in cash in order to exercise his or her options.

By electing a cashless exercise for all 1,000 shares, here’s what would happen: The company would reduce the number of shares to be received upon exercise by 725 ($7,250 divided by the $10 market value) to pay the exercise price of $7.25 per share. The employee would receive the balance of the shares (1,000 - 725 = 275).

This of course results in the optionee having a significantly lower percentage ownership of the company than was initially promised to him but without having to pay anything for that lower percentage. Obviously, the higher the market value of the company’s shares, the fewer shares would be necessary to pay the $7.25 strike price, which remains fixed.

What happens if I leave the company?

This depends on what the option agreement says. Generally, if an employee quits or is terminated without good cause (for example, in a downsizing), the employee loses all options that have not yet vested and is required to exercise his/her vested options within a short period of time (usually 90 days after termination) or else lose them. Some plans allow employees up to one year to exercise options if termination was due to their death or permanent disability.

If an employee is fired for good cause (for example, incompetence, embezzlement or fraud), he should lose all vested options and the company should have the right to buy back all vested options for $1. Allowing an employee who has cheated the company to become a stockholder is one of the dumbest things a company can do.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.”

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