Getting Started with an Employee Stock Option Plan

Stock option plans are a popular way for employers to compensate, retain, and attract employees. As a growing number of workers participate in these plans, however, issues can arise regarding their interpretation and implementation.

If you want to set up a stock option plan at your business, first and foremost, find an experienced attorney, preferably one who has worked on similar plans for companies that fit your business’s profile. Although stock option plans are considered relatively easy to establish and administer, many critical issues can be overlooked.

Stock options are securities. As such, federal and state securities laws govern stock option plans and impose specific requirements depending on the type of plan (i.e., incentive stock option, or ISO, and non-statutory stock option, or NSO). In addition, the Employee Retirement Income Security Act has set guidelines for plan trustees and administrators that if breached could lead to litigation.

A well-crafted plan eliminates ambiguity and keeps you out of legal hot water as your business grows and changes. Here are some of the issues to watch for.

Fair Market Value

One of the biggest challenges in setting up a stock option plan at a new company is determining the options’ market value. The Internal Revenue Service and Financial Accounting Standards Board have strict regulations on how the price is determined so the value can’t be arbitrarily assigned. Companies must follow specific steps for valuation or hire an independent valuation firm to calculate the price. If you don’t issue options at fair market value, negative tax consequences and possible legal action could result.

Changes in Business Ownership

Often stock option plans don’t consider the implications of a merger or sale. But when a business is acquired, many questions arise regarding how vesting will be handled and whether unvested options will be converted to options in the new company.

When you draw up your plan, spell out what actions will be taken with each possible issue. For more flexibility, indicate who will make the decisions (such as an independent committee) and on what grounds. Either way, your plan will present a clearer road map should your business change hands.

Employee Turnover

Generally, unvested options are forfeited when an employee terminates employment. However, lawsuits have been filed in cases where the employee or employees believe their company terminated them specifically to prevent them from vesting, which is a breach of state employment laws.

It’s important to outline specific rights regarding unvested options for terminated employees. Although not a fail-safe solution, it should help you avoid most litigation.

Plan Mismanagement

Under federal law, the people responsible for overseeing a stock option plan must provide information about plan features and funding, provide a grievance and appeals process, and act in the best interests of the plan participants. Fraudulent information concerning an employee’s entitlement to options, number of assigned shares, exercise price, or vesting schedules is a violation of the act and a common source of litigation. Choose your plan administrators wisely.

Stock option plans make a great deal of sense for companies, and if well thought out they can be a low-maintenance benefit to employees. Just be sure to have your final plan reviewed by a financial professional.