Employee stock options are a valuable form of corporate compensation, offering employees the opportunity to share in the success of the company they work for. Stock options aren’t actual shares of stock—they’re the right to buy a set number of company shares at a fixed price, usually called a grant price, strike price, or exercise price. Because your purchase price stays the same, if the value of the stock goes up, you could make money on the difference.
Types of Employee Stock Options
There are two types of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). These differ in several key aspects, including eligibility, tax treatment, and flexibility. These mainly differ by to whom they can be granted, as well as how they’re taxed.
ISOs are subject to more stringent regulatory requirements and can only be granted to employees of the company (including parent and subsidiary companies). They are not available to contractors, consultants, or board members. ISOs offer the possibility of special tax treatment. If the shares are held for the required period (at least one year after exercising and two years after the grant date), taxes may only be due upon selling the shares. On the other hand, NSOs typically require taxes to be paid both upon exercising the option and selling the shares. They are a more flexible form of equity compensation used by companies worldwide to incentivize employees and other service providers.
What are incentive stock options (ISOs)?
Incentive stock options (ISOs) are a form of equity compensation offered by companies to their employees. While the term “ISO” and its specific tax treatment are primarily associated with the United States, the general concept of providing employees with preferential stock options exists in various forms across different countries. These stock options grant employees the right to purchase company shares at a predetermined price (often called the exercise price or strike price) within a specified period. They are usually reserved for employees of the company or its subsidiaries, excluding contractors, consultants, or non-employees. The price at which the employee can purchase shares is typically set at or above the fair market value of the stock on the grant date.
These options often come with a vesting schedule, requiring employees to remain with the company for a certain period before they can exercise their options.There’s usually a limited time frame within which the options must be exercised before they expire.
What are non-qualified stock options (NQSOs)?
Non-qualified stock options (NQSOs) are a form of equity compensation used by companies worldwide to incentivize employees and other service providers. While specific regulations may vary by country, the fundamental concept of NQSOs remains largely consistent across jurisdictions.
NQSOs grant the recipient the right, but not the obligation, to purchase a specific number of company shares at a predetermined price (often called the grant price, strike price, or exercise price) within a specified time frame. This price is typically set at or above the fair market value of the stock on the date the options are granted.
Unlike some other forms of stock options, NQSOs are not bound by as many regulatory restrictions, making them a flexible compensation tool. They can be issued to a wide range of individuals, including employees, contractors, consultants, and board members.
Vesting is a crucial concept in NQSOs. It refers to the process by which the option holder earns the right to exercise their options over time. A common vesting schedule might span four years, with a one-year “cliff” (meaning no options vest for the first year) followed by monthly or quarterly vesting thereafter. This structure encourages long-term commitment to the company.
Once vested, the option holder can choose to exercise their options – that is, purchase the shares at the predetermined price. If the current market price of the shares exceeds the exercise price, the option holder can potentially profit from this difference.
Unlike some other forms of stock options, NSOs are not bound by as many regulatory restrictions, making them a flexible compensation tool. They can be issued to a wide range of individuals, including employees, contractors, consultants, and board members. This flexibility is particularly useful when granting stock options to employees of foreign branches or subsidiaries who are actively engaged in the company’s operations.
How Companies Allocate Option Pools and Their Ideal Size?
When establishing an employee stock option plan, companies need to determine the size of their option pool – the number of shares set aside for employee stock options. The size of the option pool can vary depending on the company’s stage, industry, and compensation strategy.
Typically, early-stage startups might allocate 10-20% of their equity for an employee option pool. As companies grow and mature, this percentage often decreases. More established companies might have option pools of 5-15% of total equity.
Factors to consider when determining option pool size:
- Company stage and growth projections
- Hiring plans and competitive landscape
- Investor expectations and dilution concerns
- Industry standards and benchmarks
It’s important to strike a balance between having enough options to attract and retain talent, and minimizing dilution for existing shareholders. Companies should regularly review and adjust their option pool size as needed.
Employee stock options regulated in Armenia
According to Article 41 of the Armenian law on joint-stock companies, companies can distribute shares or derivative financial instruments to their employees, including executive officers. These can be outlined in the company’s charter or through an employee stock ownership plan (ESOP) approved by the general meeting of shareholders. An ESOP is an internal legal act of the company that outlines the cases, conditions, and procedures for employees to acquire, use, alienate, and repurchase company shares or derivative financial instruments. This plan provides a framework for implementing ESOs within the company.
Decisions to approve an ESOP or make changes related to employee stock ownership (including amendments to the company charter) are made by the general meeting of shareholders. These decisions require approval by 3/4 of the voting shareholders present at the meeting, but not less than 2/3 of all voting shareholders, unless the company charter specifies a higher threshold.
Are there limits on the number of shares that can be distributed to employees?
Yes, there are restrictions. The total nominal value of shares distributed to employees, including those resulting from the final settlement of derivative financial instruments, must not exceed the authorized capital. Moreover, the voting rights attached to these shares must not exceed 25% of the company’s voting shares.
Can companies place restrictions on employee shares?
Companies may limit the ability to dispose of employee shares or derivative financial instruments for up to three years from the date of their distribution. This restriction must be specified in the company’s charter or ESOP. Employee shares or derivative financial instruments are distributed among employees with their written consent. Interestingly, employee shares can be provided free of charge, or the payment for shares can be less than the nominal value of the corresponding type or class of company shares.
What happens to employee shares if employment is terminated?
If an employee’s work relationship or an executive officer’s service relationship is terminated (except for retirement), the company has the right to repurchase the employee’s shares at market value, but not less than the nominal value, if the three-year disposal restriction is still in effect.
Tax Implications of Exercising Options and Potential Exemptions
The tax treatment of stock options can vary significantly depending on the type of option (ISO or NQSO) and the country of residence.
United States:
- ISOs: May qualify for preferential tax treatment if certain holding periods are met.
- NQSOs: Typically trigger taxation upon both option exercise and share sale.
- At exercise: Income tax on the spread between exercise price and fair market value.
- At sale: Capital gains tax on the difference between sale price and fair market value at exercise.
Republic of Armenia
- Exercise of stock options is not considered a taxable event.
- Sale of stocks:
- Â If sold 3+ years after exercise:Â Capital gains are tax-free.
- Â If sold within 3 years:Â 10% income tax on capital gains.
-  Dividends from ESO-acquired shares are taxed at 5%.
Legal and Tax Implications of Issuing Stock Options to Team Members Located Abroad
Issuing stock options to international team members can be complex due to varying legal and tax regulations across countries. Some countries restrict cross-border financial transactions, which could affect option exercises. Both the company and employees might face additional reporting obligations for international stock option grants.
Consider double taxation issues: For example, Armenia and the United States do not have a double taxation treaty. This means that income from stock options may be taxed in both countries without any relief.
Potential tax exemptions:
- In the U.S., non-resident employees may not be subject to taxation on NQSOs if they never perform work in the U.S.
- In Armenia, selling stocks 3+ years after exercise results in tax-free capital gains.
Whether you’re a company designing a stock option program or an individual evaluating an offer, consulting legal and tax professionals is crucial. Retrieve Legal and Tax professionals will help ensure you maximize benefits while minimizing risks in stock option plans.