Should Your Small Business Offer Stock Options to Employees?
July 18, 2022 | Last Updated on: December 15, 2022
July 18, 2022 | Last Updated on: December 15, 2022
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Stock options were once reserved for executives and upper management employees of a company or corporation. But in today’s business world, some small business owners include stock options as part of their overall compensation package for employees at every level. Should your small business offer stock options to employees? We’ll look at some of the ways it can benefit your company in just a moment. But first, a better understanding of stock options might be in order.
According to the National Center for Employee Ownership, there are approximately 6,482 small businesses participating in employee stock option plans. These plans include 5,880 privately-held companies and cover 13.9 million current and former employee participants.
Just as cash bonuses and retirement plans appeal to most employees, stock options are another way to offer more competitive compensation to attract and retain the best employees.
The main difference between a private and a public company is that shares from a private company are not traded on a public stock exchange, whereas a public company’s stock is. However, a private company can still have shareholders.
Shares for publicly-traded companies can be easily liquidated or sold. Publicly-held companies are also required to file disclosure requirements or report share transactions, but private companies aren’t obligated to do the same.
A drawback for private companies offering stock options is that it isn’t as easy to value the company through the shares as it is for a public company.
Because of the vast amount of information and data required for reporting, a public company has all the metrics available to provide an easy way to value the business.
On the other hand, a private company has to start from scratch and use traditional valuation methods to determine its fair market value. This can make it challenging to provide a concrete value on any stock options an employee has.
One similarity between private company stock options and publicly-held stock is that tax implications for both occur when the stock option is exercised. The specifics surrounding both are wide and varied, and a financial advisor or CPA should be consulted to determine any tax liabilities. But any employee who holds stock for over a year will likely have to pay a long-term capital gains tax.
Private startup companies are more likely to offer stock options, particularly when they plan to eventually go public with an IPO (initial public offering). At the same time, many companies prefer to remain private because it allows them to retain complete control of the business.
When a private company offers employee stock options, they’re not actually giving the stock shares straight away—they’re offering an employee the right to purchase shares of the company stock at a set price, called the strike price or exercise price.
If the employee chooses to exercise their right to purchase the shares or stock options, they must do so within a specified period of time. But the employee is not under any obligation to buy the shares or exercise their stock options.
The share price is typically below the fair market value of the stock at the time the employee is initially offered stock options. If the stock options go up in value down the road, the difference between the strike price and the value of the shares over time can potentially offer a significant financial windfall for your employee.
The stock option contract will usually have a date that stipulates when the option is available to be exercised and when the employee can sell their stock. The contract will also list the number of shares that can be sold.
Some companies have vesting periods during which the employee can buy the shares. An example would be a vesting schedule of four years. An employee might be allowed to purchase 20% of the shares after the end of the first year, 40% at the end of year two, 75% at the end of year three, and 100% at the end of the fourth year.
Most small businesses that offer stock options have a one-year cliff, meaning that if the employee leaves before working for the company for at least a year, they lose their unvested options. The point of the one-year cliff is to encourage employees to stay on for the entire vesting period. But many employees don’t sell their shares anyway until a liquidity event, such as the sale of the company or when the business goes public.
The bottom line is that a stock option potentially offers an employee a small ownership percentage in your business by way of shares in the company. This could incentivize the employee to remain with you long-term and work hard towards the growth of the business because if the business is successful, the shares will likely increase in value.
The two main stock options for small businesses are incentive stock options (ISOs) and non-qualified stock options (NSOs). Stock options that aren’t ISOs are usually non-qualified stock options.
There is another type of equity compensation, known as restricted stock units, or RSUs. RSUs differ from stock options in that an employee is given the stock shares rather than the employee having to exercise their right to purchase the shares. Here, the focus is more on stock options.
ISOs potentially offer a tax advantage to your employees, whereas NSOs don’t often meet the requirements for special tax treatment.
ISOs usually have long-term capital gains and aren’t taxed as ordinary income when the stock is sold. So an employee can keep the shares as long as they want and don’t have to pay any taxes on the shares until they sell them. This means the worker can hold on to more income and pay less tax while potentially making a lot of money on the shares over time.
Your employee can also convert the discount that typically would be considered compensation in a non-qualified stock option into capital gains, which would likely have a lower income tax liability than compensation would.
The advantage for employers offering incentive stock options is that the IRS doesn’t require you to pay the employer payroll tax on compensation that you would otherwise have to pay for non-qualified stock options. Basically, you’re transferring the tax responsibility of that portion to the employee.
Also, startups rarely benefit from a non-qualified stock options tax deduction. While non-qualified stock options can yield a tax deduction, it’s rarely significant unless your company is profitable. That often isn’t the case until you’ve been in business for many years.
Many entrepreneurs believe that offering stock options to workers is a powerful incentive for an employee to give their best work performance. This is especially true and important at the initial startup stages of a business.
Startups and small businesses often can’t offer their employees the large salaries that a publicly- traded corporation can. A small, growing business usually has a limited cash flow to meet operational expenses, including salary and compensation for its employees.
Some business owners negotiate with workers to pay them smaller salaries and include stock options to make up the difference. The stock options potentially give employees ownership in the business, however small that ownership ends up being, and can result in a lucrative payoff if the startup succeeds.
At the same time, many business owners realize that a competitive salary with stock options attracts higher-quality employees, so aren’t afraid to pay a high wage and include stock options.
Ultimately, the goal is to create a compensation package that rewards employees and values them for what they’re worth, incentivizing them to be engaged, productive employees.
Probably the main advantage to you as an employer in offering stock options to your employees is that you can potentially bring employees on board and offer a lower salary with stock options that will potentially result in stock ownership for your workers. This is a particularly attractive compensation model for startups or service-based companies that are limited in cash, as it won’t cost you any money upfront to issue them.
For instance, you might offer an employee a salary that includes 80% cash compensation and 20% stock options. If you have three employees earning a regular salary that would normally be $100,000 per year, offering stock options could save your small business $20,000 a year for each employee, resulting in a $60,000 annual savings that you could potentially use to invest in other areas of the business.
There are so many things to consider when deciding what is best for your small business, not the least of which is remembering that if an employee exercises their option, it dilutes your share of ownership in your business.
If your only goal in offering stock options is to conserve your cash flow, you might consider getting a working capital loan.
Before making a final decision on whether or not to offer stock options, consult a financial advisor about all the potential ramifications of doing so.
As a small business owner, you’ll have many financial decisions to make over the course of running your company. It’s also advisable to team up with a funding specialist who can help make some of those decisions a little easier. Biz2Credit has partnered with entrepreneurs for 15 years in helping to provide fast turnarounds on small business loans.
Chicago business owner Mohammad Mansoorie understands the value of “mutual partnership” as he calls it. He wanted to have the ability to expand his business as opportunities arose but needed a committed loan provider. Biz2Credit was able to fund his business venture in 5 days.