What Entrepreneurs Need To Know About Stock Options

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

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Stock options are about the only method many companies, including the high tech "gazelles," as rapidly growing tech-centric firms are called, can use to attract the experienced and high quality management they need. Since this business began, tech investors, including venture capitalists, have recognized that "you bet the jockey and not the horse." However, in order to attract qualified jockeys, the parties have to find a way to pay the potential managers in a currency which is meaningful to the recruit and which the issuer can afford. Inducing someone to take a new job (and leave, in many cases, a comfortable environment) often requires extraordinary potential rewards. Frequently, there is not enough spare cash around (cash being a scarce resource in a business dependent on R&D for growth) with which to motivate the jockeys to make a change; and growth companies need the best jockeys, in view of their growth ambitions. Equity-flavored compensation (a piece of the upside so to speak) is, therefore, an imperative.

The problem with many commentaries on the subject of stock options is that the writers have apparently failed to understand features which make options particularly attractive (prominently not, anymore, including the accounting treatment). First, options represent the principal pieces of paper which afford the executive a piece of the upside (at least the only type in current use) and which do not entail a tax as of the date of the award. To return again to the point with which we started this discussion, there may be little cash to spare by, among others, gazelles in their super-growth stage. Certainly not enough to fund tax payments to the Treasury (whether the payor is the individual or the company). Stock options work because there is no tax involved as of the date of grant; restricted stock often does not do the job because tax is owed when the grant occurs. Moreover, restricted stock, which makes the recipient an instant stockholder, is unlikely to be distributed democratically; assuming the stock has value, only the top echelon, those who can afford to pay the tax, will be receiving restricted stock awards; an unlikely policy for the government and the SEC to adopt expressly.

Another virtue of stock options (often neglected as far as I have been able to see) is that the bonus compensation comes from the stock market rather than from the company. The company is able to use its cash internally; the market itself is the one that makes the jockey's trip worthwhile. Stock options may be an expense in the eye of FASB but they are of no concern to, for example, creditors.

Since IRS 409A the exercise prices of the options have to be at fair market value and that may entail an opinion from an outside source but there are vendors which are not in the arm and a leg variety. Stock options are, in short, a fundamental cornerstone of our entrepreneurial economy and the trick is to grant them intelligently…not too much but certainly not too little in order to keep the jockeys in the saddle.

Joseph W. Bartlett, Special Counsel,

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