In this blog post, you'll find everything you need to know about stock options:
What options are
The startup stock option scheme
Tax considerations
Pros of options
Cons of options
Administration
Stock options are one of the most common forms of equity compensation used to motivate employees.
A stock option is a right, but not an obligation, to buy a set number of shares in the company in the future at a pre-agreed price.
Stock options are often used as an alternative to shares with restrictions (Restricted Stock Awards, or RSA). This is especially common once a company's valuation has reached a level where shares can no longer be bought at a favorable low price, for example, after a priced funding round at a high share price.
How do stock options work? 🧐
When an employee is granted stock options, they need to decide whether to accept or decline the grant.
Grants are usually given for free to employees or board members. They give the recipient the right to buy a set number of shares at a pre-agreed price at some point in the future. That window is called the vesting period.
There are two main types of vesting: time-based vesting and performance-based (or conditional) vesting. Time-based vesting is by far the most common in early-stage companies.
It's also normal for stock options to vest gradually over the vesting period. As options vest, the employee can choose whether to exercise them, converting the options into actual shares, and pay the exercise price, also known as the strike price.
If the employee leaves the company before the full vesting period is up, they lose any unvested options. It's also standard for the agreement to include a clause stating how long the employee has to decide whether to exercise their vested options after leaving. That window can vary depending on the reason for leaving.
An example: an employee is granted stock options with a 4-year vesting schedule, a 12-month cliff, and quarterly vesting thereafter. They'd need to stay for the full 4 years to earn the right to exercise all the options. After one year, they'd have the right to exercise 1/4 of the grant.
If the employee stays at the company, they can wait to exercise the options right up until the expiry date. Expiry dates vary, but are often set several years out from the grant date.
Stock options are generally considered risk-free in the sense that the employee doesn't have to invest any capital up front. If the share price is lower than the exercise price at the point of exercise, it simply doesn't make sense to exercise, which avoids locking in a loss.
We'll cover typical terms and conditions for stock options in more detail in a separate post.
Stock options for qualifying startups 🚀
The authorities recognise the power of motivated employees and how important they are to innovation and entrepreneurship.
So Norway has a dedicated startup option scheme for companies that meet the qualifying criteria. It's highly tax-efficient for both the recipient and the company. We'll cover the full details in a separate post.
You can also check whether your company qualifies using this short questionnaire.
Tax considerations 💵
No tax is triggered at the grant date. Tax kicks in only when the option is exercised.
Gains from stock options are taxed under the general rule for employment benefits, meaning, as income. (Unless the option qualifies for the startup scheme.)
The taxable benefit is calculated as: the fair market value at exercise, minus the total exercise cost the employee paid for the shares.
Any further gain on the shares after exercise is treated as capital income and taxed accordingly.
For the company: the gain from the stock option is considered a benefit and is therefore subject to the employer's social security contributions (*arbeidsgiveravgift*).
Pros of stock options 👍
No cost: Stock options are normally granted for free.
No upfront risk: The recipient doesn't pay anything on the grant date, so there's no initial risk of loss. After exercise, the shareholder is exposed to downside risk like any other owner.
Fewer shareholders on the books: For the company, that means fewer people to report to, collect votes from, and so on.
Cons of stock options 👎
Not yet a shareholder: Option holders don't become actual co-owners until they exercise the options.
Options carry no voting rights.
Options aren't eligible to receive dividends.
Tax: Gains from exercise are taxed as income, which is typically higher than the capital gains rate.
The company is required to pay the employer's social security contributions on the calculated employee benefit, where applicable.
Liquidity squeeze: When options are exercised, the recipient owes income tax (unless they qualify for the startup scheme). If the shares aren't liquid at that point, meaning, easy to sell, the recipient can end up with a hefty tax bill and no ready cash to pay it. This is a common headache for private companies.
Administration 📑
One thing worth flagging: option plans involve more administration than, say, an RSA plan, exercise, payments, and all the paperwork that comes with them. There are ways to keep the admin burden down. Combining best practices with purpose-built software saves companies a lot of time. Talk to an expert at Unlisted if you'd like to learn how.
Found this useful? Want more?
We hope so. 🦸 We'd love your feedback. Send thoughts or questions to [email protected].
If you'd like to learn how we can help you set up and run stock option schemes or other equity compensation programs in your company, feel free to book a no-obligation call with us.