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Incentive Stock Options vs. Nonqualified Stock Options

by Joe Wallin on May 15, 2013 in Business/Corporate Law, Startup Jargon/Definitions with 3 Comments

ISO vs NQOCompanies and service providers to companies frequently confront this question. Which is better: an Incentive Stock Option (aka a statutory stock option) (an “ISO”) or a Nonqualified Stock Option (aka a Nonstatutory Stock Option) (an “NQO”)?  What are the differences between these two types of equity awards?

The table below summarizes the primary differences:

Issue ISO NQO
Eligibility Limitations: Only employees (so, a nonemployee member of the board of directors can’t receive an ISO). Employees and independent contractors are both eligible.
Options taxable upon receipt? No – as long as priced at FMV at grant. No – as long as priced at FMV at grant.
Options taxable upon vesting? No – as long as priced at FMV at grant. No – as long as priced at FMV at grant.
Option taxable upon exercise? Not for ordinary income tax purposes; but spread is taxable for alternative minimum tax purposes (“AMT”). Exercise NOT subject to employment tax withholding. Yes for ordinary income tax purposes, and is subject to income and employment tax withholding. No AMT consequences.
Employment tax on exercise? No Yes
Annual limitation? Yes; only up to $100,000 in stock underlying ISOs can become exercisable in any calendar year. No
Special rule for greater than 10% shareholders? Yes; options to greater than 10% shareholders must be priced at least 110% of FMV and not be exercisable after the expiration of 5 years from the date of grant. No
Alternative Minimum Tax Applicable? Yes, on the spread on exercise. No
Character of income on sale of stock? Long-term capital gain, IF the two holdings periods are met. You have to have held the stock for 1 year after exercise, and for at least 2 years after the grant of the option. If you don’t meet these two holding periods, then the income is a mix of ordinary and long-term or short-term capital gain, depending on the spread at the time of exercise and appreciation (if any) and length of time between exercise and sale. Either long term or short term capital gain, depending on how long the stock was held after exercise.
Spread on Exercise Deductible to the company? No Yes

Conclusion

I recommend NQOs over ISOs for the reasons I summarized in the article Should I Grant ISOs or NQOs?

To reiterate my arguments in favor of NQOs over ISOs briefly:

  1. ISOs are more complex and difficult to understand for a variety of reasons, including (a) the two holding periods, (b) the annual limitation, (c) the eligibility restriction, (d) the greater than 10% shareholder rule, (e) complexities associated with disqualifying dispositions, but most significantly because of the AMT consequences on exercise when there is a spread.
  2. It is easier for companies to simply have one type of award to explain to their service providers – NQOs.
  3. Most employees don’t meet the holding period requirements of ISOs in any event – because they wait to exercise until there is a liquidity event – so the primary benefit of ISOs – capital gain on sale of the stock – is not obtained.
  4. NQOs are more transparent than ISOs because the tax withholding on exercise is more easily calculated.
  5. The spread on the exercise of NQOs is deductible to the employer.

Question & Answer: IP Assignment Agreement

by Joe Wallin on March 11, 2013 in Startup Jargon/Definitions, Startup Law with 1 Comment

Q&AQuestion:  I had some friends help me in the very early stages of my startup.  For example, one of them helped design our logo.  Another one helped me with an instructional video explaining our product (the video can now be found on YouTube).  I hate to be obnoxious, but should I have these folks sign an IP assignment agreement assigning the IP they helped me create to the company?  Do I or should I pay them anything?  I don’t want to be a jerk about this, but I also don’t want to be a fool.  Can you help me out?

Answer:  These are really good questions.  Yes, you should most definitely have these folks sign an IP assignment agreement.  It doesn’t have to be obnoxious.  It doesn’t have to be long.  Your lawyer can help you prepare a simple legal document for them to sign.  It frequently can be as short as a single page. You can explain that the company needs this for its records/due diligence files as it goes out to raise money.  Be sure to pay your friends something.  An IP assignment without any consideration could fail for lack of consideration.

Similarly, if you hire someone to consult for you, don’t have them sign a full blown consulting agreement but not pay them anything.  The  critical parts of most consulting agreements are the IP provisions.  You want to make sure whatever IP your consultants create for you belongs to your company.  This won’t happen if you don’t pay your consultant anything.  The IP assignment provisions might fail for lack of consideration.

How Many Shares To Authorize?

by Joe Wallin on March 7, 2013 in Business/Corporate Law, Startup Jargon/Definitions with 2 Comments

I am frequently asked this question: How many shares should my startup authorize in its charter (its Articles or Certificate of Incorporation)?

The trite, short answer is—authorize enough.  The longer answer is more nuanced, and basically boils down to—authorize enough to cover founder stock issuances (obviously), the equity or stock plan pool, reasonably foreseeable preferred stock issuances, and some headroom to cover the reasonably foreseeable growth of the Company.

Like other legal framework questions in starting a company, one of the tricks is to build a legal structure which is ready to accommodate growth.  As your company grows, if you have the right legal structure in place, you will have less legal work that you have to do along the way to keep up with the growth. (For example, authorize enough shares so that you don’t have to amend your charter later on to authorize more. Authorize blank check preferred so that you don’t have to amend your charter to close your first preferred stock financing, etc.)

Authorized shares are the  shares a company is authorized to issue, not the number of shares the company will necessarily issue. For example, you might authorize 10 million shares, but only issue 2 million. (“Authorized but unissued shares” are shares that are authorized but not issued. In the example just given, a company with 10 million shares authorized, but only 2 million shares issued, the “authorized but unissued shares” would be 8 million.)

Why would you authorize more than you might issue? Because you want head room. You want the shares available in case you need to issue them.

In the above example, you might need that remaining 8 million authorized, but unissued, shares for things like:

  • common shares that might be issued on the conversion of preferred shares that are issued later (if you sell 2M shares of preferred stock, you will need at least 2M shares of common stock available and reserved for that preferred to convert into later);
  • shares that will be issued on the exercise of stock options or warrants issued later;
  • shares that will be issued pursuant to other forms of compensatory equity awards (perhaps outside the plan options);
  • shares which might be issued in future financing transactions; or
  • shares which might be issued in forward stock splits (especially if you grow spectacularly fast).

Sometimes founders get nervous and want to make sure that they are forever going to control the entity – and thus if 10 million shares are authorized, they want 6 million issued to them as founder shares – to make sure that no one in the future can obtain a majority of the shares without their consent.

This doesn’t make sense and can be problematic for a couple of reasons. First, if you authorized 10 million shares, you probably included in that authorized share figure some number of authorized preferred shares, such as 2 million. So, if you authorized 10 million shares overall, and you split that between 8 million common and 2 million preferred, 2 million of the common should be thought of as set aside for the potential conversion of the preferred, thus leaving only 6 million common theoretically available – all of which you would have issued in the above example to the founders– leaving no room for an option pool.

Don’t be afraid to have headroom for future growth.

 

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