Using Stock Options to Reward and Retain Key Talent

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In this competitive business landscape, business owners must focus on attracting and retaining key talent.

There will always be competition between businesses, so much that companies often employ head hunters to recruit top talent from their competitors. Losing a key team member can be devastating and take some time to rebound from.

Additionally, no business owner wants the reputation of having a revolving door of staff. High turnover indicates business instability and hinders recruiting efforts. Top talent know they are highly sought after and they often know that they can find employment elsewhere with minimal effort.

So what techniques can you utilize to keep that talent with you? Other than the norm (pay increases, bonuses, vacation time), consider offering other perks that you can offer to attract top talent and inspire loyalty. One such perk is stock options.

Companies that rarely lose employees to competitor recruitment share similar traits. Not only do they offer the type of challenging and inspiring work environments that top talent often looks for, but they offer the same reward for outstanding performance – stock options.

What are the advantages and disadvantages of employee stock options and what is the process for granting them?

Advantages of granting stock options to your employees

  • For potential new hires considering a position with your small or startup company, a good stock option package can tip the scale in your favor. A stock option plan balances the risk/reward that comes along with working for a company that may not have a long track record.
  • Ongoing stock options (such as yearly stock option bonuses for your top 10% of performers) encourage employees to come up with ideas and solutions that create long term value for the company.
  • The adage is true that “Owners Care”.  Stock options turn employees into partial owners of your business. This means that employees have a stake in ensuring that the business is a success, have a vested interest in protecting your business’ reputation, and are more focused on aligning themselves with the company culture and goals.
  • Stock options allow companies to retain capital by granting options in lieu of cash bonuses.
  • Should the company sell or go public, employees with stock options have the potential for cash payouts.

Disadvantages of granting stock options to your employees

  • Redeemed in certain circumstances (death, retirement or departure)
  • Income tax issues – depending on the type of shares granted, and their value, the employee may have income tax exposure upon redemption of the shares. Depending on the type of shares, employees may be able to make certain elections with the IRS at the time of a grant.

Points to consider

Below is a series of questions to ask yourself when implementing a stock option plan, as well as a couple of factors to keep in mind when designing your packages.

  • What percentage of shares you will set aside for equity compensation? Where stock options have become par for the course, 20% is generally the percentage of shares that is set aside. Bear in mind, you will want to ensure you have left enough shares to cover your employment package needs.
  • What amount of shares will you grant to your Executive Officers?
  • What type of options will you grant? There are NSO’s (Non-Qualified Stock Options) and ISO’s (Incentive Stock Options).  ISO’s have IRS guidelines and requirements attached to them. You will need to decide which type of stock option will be a better incentive for your talent, and will work best with your business needs.
  • Will you offer performance grants? This type of grant is usually issued annually to the top 10% or so of employees that have made a proven, and measurable impact on your business.
  • What vesting period will you assign to the stock options?  The company will need to provide a vesting schedule.  There is usually a minimum time of employment that is necessary before the stocks can vest (such as one year of employment). It is common to let the shares vest in tranches. For example, 25% of your shares vest after one year of service, and then another 25% each year thereafter. At the end of year five of employment, employees can exercise all of their stock options if they choose.
  • What will be the exercise price and time to exercise?  When you grant stock options, you must provide an exercise price (let’s say 0.25 per share). When the shares vest, the employee can exercise their options at the exercise price (with the hope the shares would actually be worth more). You will also need to outline how long the employee has to exercise their options, and you will need to address how long they have in the case of termination. Usually the shares must be exercised within 90 days after termination/departure.
  • How will your employees pay for their exercise options? Generally, an employee will need to pay cash to exercise their option (which will also add capital to the business). However, in a few cases a cashless option is granted.
  • You should engage counsel to ensure you are in compliance with all state and federal securities laws.
  • You must create a 409A valuation. As per section 409A of the IRS code, you will need to determine the Fair Market Value of your stock in order to set your exercise price. This valuation is usually done by a third-party valuation expert.

Contact McCarthy Weidler PC for more information.

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