ESOP

What are stock options?

In this blog post, you'll find everything you need to know about stock options:

  • What are options
  • Stock option scheme for startups
  • Tax considerations
  • Benefits of options
  • Disadvantages of options
  • Administration of options

Share options are one of the most common share-based remuneration schemes to incentivize employees.

A stock option is a right (and not an obligation) to buy a certain number of shares in the company in the future at a predetermined price.

Stock options are often used in companies as an alternative to restricted shares, often called Restricted Stock Awards (RSA). Especially if the valuation of the company is at a level where shares cannot be purchased at a favorable low price. For example, after a company has raised capital in a priced share issue at a high price.

How do stock options work? 🧐

When an employee is granted a share option, the employee must decide whether to accept or reject the share option grant.

The grant is usually given free of charge to an employee or board member. This then entitles the employee to buy a certain number of shares at a predetermined price at some point in the future. This period is called the vesting period.

There are two main types of vesting; time-based vesting or performance/contingent vesting. The most common type of vesting in early stage companies is time-based vesting.

It is also normal for the share options to vest gradually during the vesting period. As the share options vest, the employee can choose whether to exercise the vested share options (convert the option to shares) and pay the exercise price, also often referred to as the strike price.

If the employee should leave the company before the full vesting period, the employee will lose the unvested options. It is also normal that the agreement contains a clause stating how much time the employee has to decide whether he/she wants to exercise the vested stock options. This period may also vary based on the reason for termination.

Let's illustrate this with an example: If an employee is granted stock options with a vesting period of 4 years, with a one-year initial threshold and further with a gradual vesting every quarter, the employee must work 4 years to obtain the right to exercise all the stock options (convert them into shares). After one year, he/she has earned the right to exercise 1/4 of the granted options.

The graph of a release schedule

If the employee continues to work in the company, he/she can wait to exercise the options until the expiration date. The expiry date varies, but is often set several years after the start date.

Stock options are considered risk-free as the employee does not need to invest capital in advance. If the share price is lower than the exercise price at the time of exercise, it does not make sense to exercise and thus realize the "loss".

We'll cover typical stock option terms and conditions in more detail in another blog post

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Stock options for startups (that qualify for certain requirements)🚀

Governments understand the power of incentivizing employees and the importance of the economy in fostering innovation and entrepreneurship.

In Norway, we therefore have a separate option scheme for startups that qualify for the requirements of the scheme. This is highly tax-efficient for both the option recipient and the company. We will cover all the details in a separate blog post

You can also check if your company qualifies for the scheme with this questionnaire.

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Tax considerations 💵

  • There is no tax on the grant date of the options. Tax only becomes applicable when the share option is exercised.
  • Gains from share options are taxed according to the basic principle for benefits in employment relationships and thus as income tax (unless the share option qualifies for the start-up scheme).
  • The benefit to be taxed is then calculated according to the following rule: The fair market price at the time of exercise, minus the cost (total exercise price) the employee paid for the shares.
  • Any additional gain on the shares after the exercise date is considered capital income and is taxed in accordance with applicable rules.
  • Only for companies: Share option gain received is considered a benefit and is therefore subject to employer's national insurance contributions_200D↩

Benefits of stock options 👍

  • No cost: Share options are normally granted at no cost.
  • No initial risk: the option recipient does not have to pay anything on the grant date and therefore bears no initial risk of loss. After exercise, the shareholder is exposed to downside risk.
  • For companies: Fewer actual shareholders to report to and collect votes from, etc.

Disadvantages of stock options 👎.

  • Shareholder: Option holders do not actually become co-owners until they exercise their options
  • The share options have no voting rights
  • The share options are not eligible to receive dividends
  • Tax: Gains from the exercise of the share options are taxed as income tax, which often has a higher tax rate than tax on capital income.
  • The company is required to pay employer's national insurance contributions where applicable for the calculated employee benefit.
  • Liquidity squeeze: When exercising stock options, the recipient must pay income tax (unless they qualify for the Startups scheme). If the shares are not liquid (readily saleable) at the time of vesting, the recipient may face a high tax liability that he/she may not have the funds to pay for. This is typically a challenge in private companies.cf_200D↩.

Administration 📑

Please note that there is more administration associated with share option plans compared to, for example, an RSA plan. This is related to exercise, payment and related paperwork. There are ways to minimize this administration burden. By using best practices combined with a bespoke software, companies can save a lot of time here. Talk to an expert at Unlisted if you want to learn how.

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Was this helpful and would you like more?

We hope you found this useful🦸 We'd love your feedback on this. Send feedback or questions to us at hello@unlisted.ai

If you would like to learn how we can help you implement and manage stock option plans or other equity compensation schemes in your company, feel free to book a non-binding call with us

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