Unlocking the Power of Equity-Based Incentive Compensation: Basics of Nonqualified Stock Options and Stock-Settled Stock Appreciation Rights

This article is the second in our series on equity-based compensation, intended to assist employers with answering a common question: What type of equity compensation award is best for our company and our employees? (The first article is available here.)

This article will provide an overview of nonqualified stock options (NQSOs) and stock-settled stock appreciation rights (SARs). As an overview, this article will address only certain key aspects of NQSOs and SARs. It is not intended to be a comprehensive discussion of every issue or consideration that applies to these types of awards. The article focuses on privately held companies and does not address the additional or different securities law, accounting, and governance considerations that apply to publicly traded companies. In addition, all discussion of taxes is limited to U.S. Federal income tax.

Beschreibung

Was ist ein NQSO?

An NQSO is a type of a compensatory stock option. An option is a right to buy shares of a company’s stock at a fixed price (the “exercise price”) over a specified period of time. An NQSO provides compensation to the option holder when the company’s stock price is higher than the exercise price. Imagine you receive an option to buy 10 shares of stock with an exercise price of $1 per share. When you exercise the option, a share of stock is worth $100 per share. So, you only have to pay $10 to purchase stock worth $1,000. The difference of $990 is treated as your compensation from your employer. 

Was ist ein aktienbasierter SAR?

A stock-settled SAR is similar to an NQSO economically, but the recipient does not have to pay the exercise price. When the SAR is exercised, the SAR holder automatically receives only a net number of shares having a value equal to the excess of the fair market value of the stock over the exercise price (the “spread”) at the time of exercise. Using the same amounts as in the NQSO example above, a SAR would result in you being issued 9.9 shares of stock upon exercise, which have a total value of $990. This same outcome can also be achieved for NQSOs, if the employer withholds shares otherwise issuable upon exercise to cover the exercise price.  

Aufgrund der Ähnlichkeit von SARs mit NQSOs umfassen die Verweise auf NQSOs in diesem Artikel generell auch aktienbasierte SARs, sofern nicht anders angegeben.

Warum werden NQSOs als „nicht qualifiziert“ bezeichnet?

The reason NQSOs are called nonqualified is because they do not meet the requirements for so-called “incentive stock options” or “statutory stock options,” which can qualify for capital gains tax treatment. For a more detailed discussion of the differences between NQSOs and incentive stock options, and the factors that should be considered in choosing one over the other, please see our article here.

Warum NQSOs gewähren?

NQSOs werden häufig von Arbeitgebern an Arbeitnehmer oder andere Dienstleister (wie Direktoren und Berater) gewährt, da sie dazu beitragen, die Interessen des Dienstleisters mit denen der Aktionäre des Arbeitgebers in Einklang zu bringen (siehe „Vorteile” unten), und aufgrund der potenziell günstigen steuerlichen Behandlung (siehe „Steuerliche Behandlung” unten).

Was sind einige typische Bedingungen für NQSOs?

Der Ausübungspreis einer NQSO wird in der Regel auf den Marktwert der zugrunde liegenden Aktie zum Zeitpunkt der Gewährung der NQSO festgelegt.

NQSOs often have a vesting schedule during which the service provider must remain employed or in service for the NQSO to become exercisable. Vesting schedules often range from three to five years in total, with some form of ratable vesting over the entire service period. One common vesting schedule among private companies in certain industries is to have 25% of the NQSOs become vested on the first anniversary, followed by ratable monthly vesting over the subsequent three years. The vesting schedule selected will typically reflect a balance between the employer’s desire to maintain a longer-term retention incentive and the need to ensure that the service provider perceives the vesting schedule as achievable.

NQSOs haben in der Regel eine Laufzeit von 10 Jahren, was bedeutet, dass die NQSO 10 Jahre nach dem Ausgabedatum verfällt und nicht mehr ausgeübt werden kann.

If a service provider’s employment or other service arrangement terminates after the service provider is partially or fully vested in the NQSO, then the vested portion of the NQSO will often remain exercisable for some period of time following the termination (unless the termination is for cause). Typical timeframes for this post-employment exercise window range from 30-90 days after an involuntary termination without cause and up to 180 days or even a full year after a termination due to death or disability.

Steuerliche Behandlung

NQSOs generally do not have any immediate tax consequences for the employer or the service provider at grant or at vesting. Instead, the tax recognition event occurs when the NQSOs are exercised. At the time of exercise, the service provider typically recognizes ordinary income in the amount by which the fair market value of the stock being purchased then exceeds the exercise price (the “spread”), and the employer will generally receive a corresponding tax deduction. In the example given above, this would be $990, which is the difference between the stock’s value of $1,000 at exercise and the $100 you paid as an exercise price. For employee option holders, the spread is generally treated as supplemental wages for tax withholding purposes and is reportable as such on the employee’s Form W-2. For non-employee option holders, the spread is generally treated as compensation and reportable on the appropriate Form 1099.

Upon exercise, the option holder generally acquires a basis in the stock purchased equal to the fair market value of the stock acquired at the time of exercise. When the stock is subsequently sold, any appreciation or decline in value would generally be a short- or long-term capital gain or loss, respectively. Using the same example as above, your basis in the shares would be $1,000 and if you later sold them for $1,500, the $500 would be capital gains.

Um die oben beschriebene steuerliche Behandlung zu erhalten, müssen NQSOs jedoch einige Voraussetzungen erfüllen, darunter die folgenden:

• The exercise price of the NQSOs must be set no lower than the fair market value of the underlying stock at the time of grant. (See “Disadvantages” below.)
• The NQSOs must relate to the stock of the entity for which the service provider provides services or a parent of that entity. NQSOs cannot generally be granted to purchase the stock of a subsidiary of the entity for which the service provider provides services.
• Die NQSO darf keine zusätzlichen Merkmale für die Aufschiebung von Einkünften über das Ausübungsdatum hinaus aufweisen.

If an NQSO meets all of these requirements, it generally will be exempt from the tax rules on nonqualified deferred compensation known as Code Section 409A and therefore receive the tax treatment outlined above. If an NQSO does not meet all of these requirements, then it may be subject to Code Section 409A, which imposes strict requirements on the timing of deferred compensation and, if such requirements are not met, a 20% penalty tax and other adverse tax consequences. Because NQSOs often do not satisfy the timing requirements of Code Section 409A, it is generally desirable that they satisfy the three requirements above to qualify as exempt from Code Section 409A. Alternatively, NQSOs that do not satisfy all three requirements above may be structured as an arrangement that is subject to, and compliant with, Code Section 409A, but doing so typically involves the option holder giving up significant flexibility regarding their ability to choose when to exercise the NQSO.

Vorteile

NQSOs bieten als Instrument zur leistungsbezogenen Vergütung mehrere potenzielle Vorteile:

• Es besteht die Möglichkeit hoher Gewinne, wenn der Aktienwert deutlich steigt, was für Mitarbeiter und andere Dienstleister sehr motivierend sein kann und dazu beiträgt, ihre Interessen mit denen der Aktionäre in Einklang zu bringen.
• NQSOs sind im Allgemeinen leicht verständlich, sodass Dienstleister sie eher als wertvoll ansehen, solange davon ausgegangen wird, dass der Aktienwert steigen wird.
• Der Optionsinhaber kann wählen, wann er das steuerpflichtige Einkommen anerkennt, indem er den Zeitpunkt der Ausübung wählt, sobald die NQSO unverfallbar ist.
• Der Arbeitgeber erhält in der Regel einen Steuerabzug in Höhe der Vergütung, die der Optionsinhaber bei Ausübung der Option erhält.
• NQSOs (im Gegensatz zu Incentive-Aktienoptionen) können an nicht angestellte Dienstleister wie Berater und Direktoren gewährt werden.

Nachteile

Zu den möglichen Nachteilen von NQSOs gehören unter anderem die folgenden:

• Because of the exercise price, NQSOs have no value to the option holder unless stock value increases above the exercise price. If the stock does not increase in value, or declines in value, NQSOs can quickly lose their motivating power or even become demoralizing if the stock value remains below the exercise price for an extended period.
• Upon exercise, the spread of the NQSO is taxed as ordinary income. There is frequently no opportunity for capital gains treatment unless the NQSOs are structured as “early exercise” options that can be exercised prior to vesting. If the option holder is an employee, the income is also subject to tax withholding and employment taxes.
• Bei Ausübung muss der Optionsinhaber den Ausübungspreis der ausgeübten NQSOs und (möglicherweise) die Quellensteuern zahlen, was eine Kreditaufnahme erforderlich machen kann (siehe hierzu einen entsprechenden Artikel hier) oder den Verkauf von Aktien erforderlich machen kann, um die Optionsausübung und die damit verbundenen Steuern zu finanzieren (beachten Sie, dass sich in diesem Punkt aktienbasierte SARs von NQSOs unterscheiden, da ein SAR-Inhaber zwar nicht den Ausübungspreis zahlen muss, aber dennoch möglicherweise seine eigenen Quellensteuern oder andere Steuerverbindlichkeiten finanzieren muss).
• To set the exercise price, the employer generally must determine the fair market value of its stock at the time of grant within the framework of Code Section 409A, which can involve incurring additional costs if an independent third-party appraisal is used. A discussion of the Code Section 409A framework for valuing stock is available here.

Sonstige Überlegungen

Wertpapiergesetze

NQSOs are considered “securities” for purposes of U.S. Federal and state securities laws. Accordingly, their grant and exercise must comply with the requirements of the Securities Act of 1933. The Securities Act generally requires that, any time a security is offered and sold, it must either be registered with the Securities and Exchange Commission or qualify for an exemption.

An exemption frequently used for NQSOs in the private company context is known as Rule 701, which generally exempts from registration securities that are offered and sold to employees, consultants or advisors of the issuer or its subsidiaries under a written compensatory benefit plan, if certain requirements are met. One frequent question is whether NQSOs can be granted to entities, such as a limited liability company that is providing services to the issuer. Subject to limited exceptions, the answer is generally “no,” because Rule 701 exempts offers and sales only to consultants and advisors who are “natural persons.” If Rule 701 is not available to exempt an NQSO, another exemption may be available, but other the other exemptions may not be as simple to satisfy as Rule 701 (for example, some of them may require that the NQSO recipient be an accredited investor within the meaning of the Securities Act).

In addition to the U.S. Federal securities laws, any grant of NQSOs in the U.S. will need to qualify for an exemption under, or comply with, state “blue sky” laws. The state “blue sky” laws where the employee or consultant resides at the time the NQSO is granted will generally apply. Certain states may require a notice filing or payment of a fee when NQSOs are granted to service providers in those states. Companies should review the applicable state “blue sky” laws before any NQSO grants are made to an employee or consultant in that particular state.

Dokumentation und Aktionärsvereinbarungen

NQSOs are normally documented using a plan that contains the main terms and conditions applicable to the NQSOs, with individual award agreements given to each recipient setting forth the particular terms and conditions of their NQSO award, such as the number of NQSOs granted, the exercise price, and their vesting period. The board of directors of the company normally adopts the plan and approves each grant, although delegation of such authority to an officer may be available.

When NQSOs are to be exercised for private-company stock, it is often prudent from the employer’s perspective to require the service provider to enter into a stockholders’ agreement or similar agreement that will govern the service provider’s ownership of the stock following exercise. A stockholders’ agreement can provide valuable protections for the employer and its other stockholders by, for example, limiting the transfer of stock (often by making it subject to a right of first refusal), ensuring that the employer has the ability to repurchase the stock if the service provider leaves employment or ends the service relationship and requiring the service provider to participate in a merger or other sale transaction that is supported by the other stockholders.

As we noted at the beginning of this article, because the article is intended as an overview, it addresses only certain key aspects of NQSOs and SARs and does not provide a comprehensive discussion. If you have questions about the topics covered in this overview of NQSOs and SARs not addressed in this article, or if you would like to explore other equity compensation alternatives, please stay tuned for further articles in this series, or contact your Foley attorney for more information.