Employee Stock Option Basics: Considerations & Best Practices

Stock options can be a great way to motivate key employees, help them feel more invested in the future of the company, and make overall compensation plans more attractive to current and prospective employees. For these reasons, it is becoming increasingly popular for companies to issue stock options to their employees.

Large, publicly-traded companies such as Starbucks and Southwest Airlines grant stock options to many, or all, of their employees. Start-ups may also grant stock options to employees who take the risk to work with the company at an early stage with the hope of large payouts once the company goes public or is purchased.

If your company is considering granting stock options to your employees, below are some best practices and considerations to keep in mind prior to rolling out an employee stock option plan.

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Employee Stock Option Basics

An employee stock option is a contract issued by an employer to an employee to purchase a set number of shares of company stock at a fixed price through an established period of time.

The two classifications of stock options issued are incentive stock options (ISO)—which can only be granted to employees—and non-qualified stock options (NSO), which can be granted to anyone, including employees, consultants, and directors.

Key Considerations

As you set-up your employee stock option plan, it is important to consider the following:

• • Amount of ownership you are willing to dedicate to employee equity compensation.
  • Impact of stock options on the valuation and/or dilution of your current investors and owners of the company.
  • A company valuation (required under IRC 409A) will be necessary to determine the underlying price per share of your company’s stock. Typically this must be performed by an outside valuation professional on an annual basis and may be costly.
  • Timing and size of grants, including an expectation of future grants to current and future employees.

Accounting Implications of Stock Option Plans

• • Under Accounting Standards Codification (ASC) 718, companies are required to record stock compensation expense over the vesting period of the stock option grant. As this amount can be difficult to value, it is typical for companies to use an outside professional or program to calculate this expense on an annual basis.
  • As stock compensation is a non-cash expense, it is typically ignored by non-audited companies; however, it can be a costly and lengthy process to record past years of expense in the first year of an audit. Therefore, keeping detailed records of option grants, exercises, and employee termination dates from the beginning will greatly decrease the time required to calculate the expense and related financial statement disclosures if/when you require audited financial statements.
  • Options issued to consultants for services must be revalued each reporting period, thus complicating your expense further.

Implementing a New Stock Option Plan

Implementing a new equity compensation program often requires assistance from outside your organization.

• • Lawyers will be required to compile the plan documents and individual stock option award agreements to ensure you are meeting all legal and compliance standards.
  • Professional help can also be beneficial in designing and implementing your plan.
  • A tax professional should be consulted to ensure you are issuing options in a way most tax beneficial to your company and employees.

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If you need assistance calculating the stock-based compensation for audit purposes, or would like to better understand some considerations for incentivizing your employees or attracting new talent, contact us today.