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.

Description

What is an 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. 

What is a Stock-Settled 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.  

Because of the similarity of SARs to NQSOs, this article’s references to NQSOs will generally encompass stock-settled SARs, except as otherwise noted.

Why are NQSOs Called “Nonqualified?”

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.

Why Grant NQSOs?

NQSOs are often granted by employers to employees or other service providers (such as directors and consultants) because they help to align the service provider’s interests with those of the employer’s shareholders (see “Advantages” below) and because of potentially favorable tax treatment (see “Tax Treatment” below).

What Are Some Typical Terms of NQSOs?

The exercise price of an NQSO is most commonly set at the fair market value of the underlying stock on the date the NQSO is granted.

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 typically have a 10-year term, meaning that the NQSO will expire, and can no longer be exercised, 10 years after the date of grant.

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.

Tax Treatment

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.

To receive the tax treatment described above, however, NQSOs must satisfy a few requirements, including the following:

• 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.
• The NQSO may not have any additional feature for the deferral of income beyond the date of exercise.

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.

Advantages

NQSOs have several potential advantages as an incentive compensation vehicle:

• There is a possibility of large gains if the stock value increases significantly, which can be highly motivating to employees and other service providers and help to align their interests with shareholders.
• NQSOs are generally easy to understand, making it more likely that service providers will perceive them as valuable as long as the stock value is believed to be likely to increase.
• The option holder can elect when to recognize taxable income by choosing the time of exercise once the NQSO is vested.
• The employer generally receives a tax deduction corresponding to the compensation recognized by the option holder upon exercise.
• NQSOs (in contrast to incentive stock options) may be granted to non-employee service providers, such as consultants and directors.

Disadvantages

Some potential disadvantages to NQSOs include the following:

• 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.
• Upon exercise, the option holder must pay the exercise price of the NQSOs being exercised and (potentially) the withholding taxes, which may require borrowing money (see a related article here) or selling shares to finance the option exercise and related taxes (note that stock-settled SARs differ from NQSOs here in this regard because a SAR holder is not required to pay the exercise price, but still may be required to fund their own withholding taxes or other tax obligations).
• 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.

Other Considerations

Securities Laws

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.

Documentation and Stockholders’ Agreements

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.