Is your private company considering offering employee stock options?
Employee stock options can be a way to share the successes of your privately owned business as part of a compensation package with highly invested employees, especially if you are a startup eyeing an IPO or acquisition. However, for non-publicly traded companies, there are several things to keep in mind when building employee stock option plans. We’ll cover these considerations below.
Ownership Dilution
Offering stock options dilutes the ownership stake of existing shareholders. You will need to assess how much dilution is acceptable and communicate this clearly to any other investors or stakeholders your company may have.
Because offering employee stock options means that your employees will own a share of the company, we recommend offering employee stock options only to select employees who are invested in the long-term success of the company.
The company should also have a clear strategy for managing its capitalization table as employees exercise their options.
Determining Fair Market Value
Non-publicly traded companies must establish a fair market value for their shares. This is important for setting the exercise price of the options and for tax compliance, particularly under IRS rules like Section 409A (hence why it is often called a “409A Valuation”). Regular valuation updates are also necessary when offering employee stock options.
While it is not mandatory for an organization to engage with an outside company for a formal valuation, we highly recommend working with a third-party expert, given the risks involved with setting a valuation yourself. If you set option prices below fair market value, you AND any employees who hold stock options could face significant IRS fines.
Limited Liquidity for Shares
Since the company is not currently publicly traded, employees have few options to sell their shares. It’s important to set expectations with employees about the limited liquidity until an exit event occurs, such as an IPO or acquisition.
ISOs vs. NSOs
You will need to decide between offering incentive stock options (ISOs) or non-qualified stock options (NSOs), which each have different tax treatments for employees and the company. ISOs can sometimes qualify for favorable tax treatment.
With both options, employees may face taxation on exercise, and it’s important to educate your employees about this.
Work with a Landmark Financial advisor
Whether you’re considering offering employee stock options or building a retirement plan for your company, we can help you make strategic decisions for your business. Get started with a Landmark Financial advisor.
This material was created by Starling Digital for use by Landmark Financial, LLC and does not represent the views and opinions of Avantax Wealth Management or its subsidiaries.