Stock Options: Critical for Growing Companies but Know What You’re Doing
Observations from TechPoint’s December 13th CFO Roundtable presented by CliftonLarsonAllen
While each speaker had a unique story and perspective, the three panelists leading the discussion at TechPoint’s December 13th CFO Roundtable agreed that stock options are an exceptional tool to have in your overall compensation arsenal, and that the advice of a knowledgeable lawyer is critical to getting stock options right.
What are stock options anyway? Marc Sciscoe, a partner with Ice Miller LLP who specializes in employee benefits and executive compensation, explained that stock options are simply a right to purchase stock in a company for an exercise price that is given on the date of the grant.
Simplicity is short-lived in a conversation about stock options, however, mostly due to IRS Section 409-A regulations. Sciscoe highlighted one key provision that bears repeating: the exercise price for stock options cannot be less than the fair market value of the company. The penalties for undervaluing company stock are severe for employees exercising their options because they are taxed on the undervalued spread plus 20 percent income tax. The resulting tax burden for employees would be 40-60 percent out of their own pockets, which is a bitter pill to swallow for a supposedly “free benefit.”
“The biggest mistake I’ve seen [with stock options] is not keeping good records, or not having any evidence of this option – that somebody thinks they got – was ever granted …” Sciscoe said. “It can’t be emphasized enough, it comes up when the business is sold or there is a new round of financing.”
Sciscoe outlined three important steps to avoiding mistakes with stock options:
- Have a written stock options plan.
- Follow the plan.
- Document that you followed the plan.
It may seem elementary, but Sciscoe recounted a story about the sale of a company whose CEO granted options to employees for years outside of the approved structure, which was problematic for both the company and the apparent option holders trying to determine the value of options without an official record of grant dates and exercise prices.
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TAKEAWAYS from TechPoint's CFO Roundtable presented by CliftonLarsonAllen
- Options are an amazing tool to attract and retain key employees for a startup. As most startups can't pay what large corporations can in a normal salary, stock options are a tool in the startup's belt to level the playing field and compete for the best talent. Stock options allow startups to attract top-level talent at below-market rates: the options serve to "make up" the difference between market rate and the actual salary the startup can afford.
- Stock options are best for high-growth startups that have a liquidity event (IPO or acquisition), not necessarily closely-held businesses that won't have a liquidity event.
- Dustin Sapp from tinderbox shared a "3-lever" compensation plan that we (BlueBridge) are planning on establishing. The three levers are wage + options + bonus (based on company revenue).
- A key piece of stock options is education. A startup MUST educate its employees about the value of stock options.
- Always hire a great attorney and great accountant to help with the compensation plan for your startup. Fees for doing it wrong and not being exempt from 409(a) can be extremely painful and expensive for a startup.
Panelists Dustin Sapp, president and co-founder of Tinderbox; and Jim Zaloudek, CFO of T2 Systems; both praised stock options as very good, very useful tools for comprehensive compensation offerings that are as good and useful for the employee as they are for the employer.
Stock options are a great way to incentivize employees, Sapp said. Everybody at Tinderbox has options. The company offers a four-year 25 percent annually vesting schedule and Sapp said they have gone out of their way to make options as employee-friendly as possible because it’s important that employees understand and value their ownership stake in the company. For example, they struck clauses from the original plan that favored the company, such as being able to buy back options at any time for any reason. It just didn’t send the right message.
Tinderbox is a rapidly growing software company whose success is driven by the workforce talent they are able to attract. According to Sapp, they have been successful to date hiring people at or below market rates and bridging the gap with bonus structures and stock options.
“… The reality is you build wealth through big events, big exits, not through a salary you make year over year,” Sapp said. “So the idea that they can have ownership in what we’re doing beyond just the team motto of what we’re trying to build, this is actually their company that they are trying to build and have success with as well, has been a really key element to us bringing in that key talent.”
Tinderbox wants stock options to be something employees are excited to participate in, not just one of a laundry list of benefits “and by the way you get five stock options, too,” said Sapp.
Similarly, Zaloudek told the story of Mike Simmons founding T2 Systems in 1994, and at the time his company also wasn’t able to pay market rates. A stock options plan was put into place in 1999 and another follow-up plan was implemented in 2002. Zaloudek said the stock options plans served their purpose of keeping valuable workforce talent in place as the company grew. Next, T2 Systems moved into a type of option called phantom stock, which basically promises to pay cash at some future liquidity date, in an amount equal to the market value of a number of shares of its stock. According to Zaloudek, the day the phantom stock options were exercised during a funding round was a very happy day at T2 Systems. The wealth created was life-changing for some – it paid for an adoption, some employees bought cars, etc.
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Jim Zaloudek (center) stresses the importance of educating your employees about stock options so that they recognize their options as the exceptional benefit you intend them to be. (Left to Right) TechPoint President and CEO Mike Langellier; Randie Dial, Partner with CliftonLarsonAllen, LLP; Marc Sciscoe and Dustin Sapp.
Zaloudek and Sapp agreed that employers should not expect their below-market salary rates to last forever. It is important to try to get salaries up to market rates as quickly as possible. Paying below market rates is something you do because you have to as a startup, but if it persists it could damage the trust relationship between employer and employee.
Savvy prospective employees will ask questions about stock options that offer additional insight into the employee’s values system, such as how many outstanding shares there are?, and what percentage of the company does 100 shares really offer?, for example.
“I ask that question [Do you value stock options?] the very first interview I have with somebody to understand where their mindset is, to understand where they fit culturally with the company,” Sapp said. “Will they have the same kind of drive that everybody else does and be motivated by the same things?”
Having three compensation levers – salary, bonus and stock options – offers Tinderbox maximum flexibility to attract and retain the right team, and it certainly proved to be a productive model for T2 Systems as their business grew through several liquidity events.
The December 13, 2012 TechPoint CFO Roundtable presented by CliftonLarsonAllen was entitled “The Challenges & Advantages of Stock Options & Other Deferred Compensation.” Close to 30 tech executives attended the panel discussion featuring Jim Zaloudek, CFO of T2 Systems; Dustin Sapp, President and Co-Founder of Tinderbox; and Marc Sciscoe, Partner with Ice Miller LLP as panelists and moderator Randie Dial, Partner with CliftonLarsonAllen, LLP.
Are you a CFO or executive-level professional interested in attending the next TechPoint CFO Roundtable? Contact Elizabeth Anderson of TechPoint at firstname.lastname@example.org or call 317-275-2080 to request an invitation.