In a previous post, we mentioned that there are basically two types of options plans (i) incentive stock option pans and (ii) non-qualified stock option plans.

Before explaining these option plans in more depth, first we want to reiterate the importance of stock option plans. These plans allow employees to share in the financial upside for a company and helps to ensure that employees are aligned with business from a medium and long-term views. In addition, by using stock options to compensate employees versus cash payments, companies help to generate more cash flow, which could be reinvested in equipment, technology or even hiring additional employees.

Stock options are commonly used in startups and venture capital companies because these companies generally don’t have much cash. Further, people work for startups and venture capital companies because they are seeking higher reward for taking more risk. In addition, people oriented businesses like consulting firms or investment banks also use stock options prevalently.

Stock options are normally subject to vesting requirements (see definition below) and certain other conditions. If you are looking at business for sale, you should review the company’s current stock option plan (if it has any) and if you need to make any changes. If there is no option plan, you should need to decide whether one should be put in place.

Incentive Stock Option Plans

A company allows its employees to buy a certain number of shares at a fixed price over some specified period of time. This fixed price is commonly referred to as the grant price. Incentive stock options are subject to special tax treatment.

For example, a company may grant an employee the right to buy 1,000 shares at a $1.00 per share over the next two years. In this example, the grant price would be $1.00.

Non Qualified Stock Option Plans

Non qualified stock option plans are commonly referred to as NSOs. These plans are similar to th incentive stock option plans except for taxation. For NSOs, the employee must pay a stock option tax whether he sells the shares or holds them upon exercise.

Definitions

• Grant Price, Exercise Price, Stock Option Price) - price that an employee receives the stock options. Basically, this is the cost basis for the employee.
  • A good example would be a public company. Let’s assume a company grants an employee options at a price of $50 and the company’s stock is trading at $60. The grant price is $50. This is obviously good for the employee since the stock price is above the grant price. However, this is not always the case, which leads us to our next point.
• Underwater Options - when the grant price is below the current value of the stock.
  • Let’s go back to our public company example. However, let’s now assume the grant price was $70 and the stock is still trading at $60. Clearly, the employee does not want to exercise the options since he or she will be down $10 per share right off the bat.
• Vesting Schedule – generally, while employees may be granted stock options, these options are still subject to a vesting schedule. This means that the employee doesn’t own the options until the vesting requirements are met. Vesting requirements could be time and/or performance based.
  • For example, let’s assume at the end of 2008, an employee was granted 1,000 options. These options are subject to vesting over the next four years with 25% vested per year. This vesting schedule means that at the end of 2010 (year 2), the employee has 50% vested, or 500 options.
  • If an employee leaves or is terminated, only the vested options are able to be exercised and are generally subject to other conditions.