Why issue stock options?
By: Jesse Jones
Stock Options vs. Common Stock
Many businesses issue various forms of equity to key employees. They do this because it helps align interests and puts the business as a whole in the best possible position to succeed. Companies commonly issue stock options to their employees instead of common stock. But why? This article explains the reasoning behind issuing options and compares that against issuing shares of common stock.
What rights do stockholders have? Stockholders have the right to vote on things like who fills the seats on the board of directors, whether or not to sell the company, and other issues. In addition, stockholders have rights to dividends (if the company pays out profits to its stockholders), and a proportionate share of the proceeds on the sale of the company.
What rights do option holders have? A stock option does not entitle the holder to any rights that a stockholder is entitled to, such as voting rights, rights to dividends, a share of the company’s profits, a portion of the sale of the company. In fact, the only thing that a stock option gives the holder is the right to purchase shares at a certain price at some point in the future.
It sounds like common stock is better, so why do companies issue options? One misconception is that vesting schedules can only be applied to option grants (and not common stock). This is false. A vesting schedule is a time-based or milestone-based metric that provides a point at which a recipient is no longer at risk of losing options (or shares of common stock). When options vest, the recipient has the right to exercise the option (and when shares vest, the company no longer has the right to take them back). A standard time based vesting schedule is as follows: 25% of the options (or shares) vest after 1 year, and then the remaining options (or shares) vest monthly thereafter for 3 more years. If the employee were to leave the company prior to full vesting, the unvested options (or shares) would be lost. Vesting schedules can be applied to grants of options and common stock.Now, to answer the question - the main reasons companies issued stock options are that options can be granted (1) at no present cost to the employee, and (2) with no current tax ramifications. Common stock, on the other hand, either has to be purchased at the time of issuance, or the employee has a difficult choice to make with respect to tax payments.
An example.
Andrew is issued a stock option to purchase up to 100 shares of common stock of Wingfeather, Inc. at an exercise price of $1 per share. In other words, when Andrew wants to exercise his options, he will need to pay $100 to Wingfeather, but it doesn’t cost Andrew anything today. Employees and employers alike sometimes find it confusing that the employee would ever have to pay anything out of pocket. But remember, the purpose is to incentivize the building of value. $1 per share is the value of the company at the time Andrew is issued the options. If Wingfeather is sold 5 years later for $10 per share, then Andrew will pay $100, get his 100 shares, and then sell those shares for $10 per share ($1,000). Andrew’s upside/profit is $900, and he will pay taxes on $900 when he sells his shares in the sale of Wingfeather, Inc.Let’s assume instead that Wingfeather issued 100 shares of common stock (not options) to Andrew. Would you expect Andrew to pay $1 per share at the time he is issued the shares? Probably not because Andrew is an employee and this is supposed to be equity compensation - not an investment. So Wingfeather issues Andrew 100 shares of common stock (that are worth $1 per share) and Andrew pays nothing for those shares. That looks a lot more like compensation, and the IRS agrees. Andrew will pay ordinary income tax on the value of the shares he receives ($100 x his income tax rate) when he receives the shares*. The problem with that scenario for most employees is that, unlike salary or cash bonuses, Andrew is not receiving cash to pay the tax with. That puts Andrew in a tough spot because (1) these shares are subject to vesting (i.e. he might lose these shares if he leaves the company), and (2) the value of the Wingfeather shares may never exceed $1 per share. If either of those things happen he’ll never recoup the tax money that he pays (*click here for a discussion on the timing of the tax payment).
Instead, by issuing stock options, Wingfeather, Inc. gives Andrew the ability to wait and see if buying the shares for $1 is worth it or not. If Andrew leaves Wingfeather for another opportunity then he may lose his options but at least he isn’t also losing his cash. If he stays with the company and 5 years later a buyer purchases the whole company at $10 per share then he can exercise the options and share in the value he created. Stock options are not taxable at issuance, so there is no out-of-pocket cost until either exercise of the option (if the option is non-qualified) or upon an exit (if the option is an incentive stock option).
The tax benefits of receiving options as opposed to shares of common stock almost always make it significantly better for employees to take stock options. Issuing options instead of common stock removes one element of risk for the employee, and there is plenty of risk associated with companies that issue stock options.
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