Do I Need a Stock Option Plan?
As seen in Business Black Box
Q2 2010 Edition
The basic underlying issue when you discuss stock options with a client is incentive compensation – what can the client do with compensation to get employees to give their best for the business? Often, the client is also dealing with a related issue – employees want, or the client wants to give them, a "stake in the business" so they will act and feel like owners, not hired hands who punch the clock for a paycheck. Stock options should not be used without careful consideration, however. Some key issues include the following:
- Options as compensation for lower pay. Stock options can make sense for companies that use them to make up for lower cash compensation. Most commonly, this is done by new and growing companies that simply do not have the cash to pay the kind of salaries that their employees could obtain elsewhere.
- Options to provide competitive compensation. For certain positions and in certain industries, stock options are seen as a basic component of compensation, and you simply cannot attract good talent unless you offer stock options. Historically, this has been particularly true with various types of technology companies such as software companies. Stock options or other stock compensation are also a necessary part of the compensation package for executives at public companies.
- Options for key employees. The incentive value of stock options is greatest for key executives whose actions can directly affect the value of the company, and therefore the value of the options. Lower level employees in most companies generally are not going to think that they personally can increase the value of the company.
- Option plan and administration requirements. Stock options are complex and need to comply with multiple areas of law, most notably tax, securities and corporate law. So unless you have an unhealthy appetite for risk, you need experienced legal counsel to draft stock option plan documents and advise you on the specific actions necessary to properly establish the plan. Once the plan is established, there are numerous administrative tasks that require careful attention to ensure that stock option awards are properly granted and the vesting, forfeiture and exercise of options are correctly handled. Failure to properly establish and administer the plan leads to employee lawsuits and/or legal violations.
- Securities law liability. Speaking of legal violations, stock options are securities. If you don"t handle stock options properly, you can expose the company to civil and criminal liability under state and federal securities laws. In the worst cases, company officers and directors can also face personal civil and criminal liability.
- Minority shareholder rights. An employee who exercises a stock option is no longer just an employee. They are now also a shareholder. As a shareholder, they have all of the legal rights of a shareholder as well as an employee, which can add to your headaches if the company and the employee part on bad terms. This risk is primarily an issue for private companies, and there are ways to reduce this risk significantly, but again the company must be careful and get experienced legal advice to use stock options.
- Alternatives to stock options. Given the complexity and legal issues associated with stock options, a company should always consider whether another type of compensation structure could better accomplish the company's goals. Alternatives such as restricted stock and cash bonus programs have their own complexities and risks, of course, but after reviewing the pros and cons of options, there are many cases where a client will find that an alternative better fits their objectives.