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San Diego Businesses: Using Stock Options as Employee Compensation

If you run your San Diego business as a non-public corporation, one method of compensating your employees for their hard work – particularly upper management employees – is by issuing shares of stock as part of their compensation package. This can also be done for San Diego Limited Liability companies and for other corporate forms. This is called “equity compensation.” Issuing stock or ownership units is particularly useful for startup companies that might not have cash or other liquid assets to pay employees in a more traditional manner. Employees are often happy to accept the stock or ownership interest since it gives them hope that they can share in the wealth being created by their work and efforts. San Diego and California corporations may implement stock option plans to sell unissued shares of stock as employee compensation. See Cal. Corp. Code, § 408.

However, there are many issues to consider before embarking on a stock option incentive plan or other forms of equity compensation. Here is some basic information and some issues to consider.

San Diego Business Law: Types of Stock Option Plans

Basically, there are two common types of stock options – nonstatutory stock option plans or an incentive stock option plans.

A California nonstatutory stock option plan allows the board of directors to set up a plan to offer stocks to employee without price restrictions or restrictions with respect to exercise period or holding periods. Although rare, such plans could be straightforward grants of stock without restrictions or conditions. By contrast, a California incentive stock option (“ISO”) plan is an offer to sell shares of stock or ownership interests in the business entity to employees at certain pre-set prices at some point in the future (or upon the reaching of set milestones or goals).

San Diego Business Law: Issues to Consider

As noted above, stock options should not be implemented without considering all the goals of the business and all the legal and tax issues.

Tax Issues

Tax issues are crucial with respect to stock options as compensation. The first and most obvious reason is that stocks for a non-publicly-held company are not easily converted into cash, but taxes will have to be paid in cash. Thus, providing $1 million in stock might result in a $200,000 tax bill, which is a disaster if the employee does not have $200,000 and/or cannot sell the stock.

Significant tax consequences also turn on HOW the stock option is made. A nonstatutory option might result in the value of the stocks being treated as ordinary income. On the other hand, a properly qualified ISO might result in the certain increases in stock value being treated as capital gains. As many know, ordinary income is taxed higher than capital gains income. All of the various stock option plans have quite divergent tax consequences.

Furthermore, to obtain the desired tax consequences, your company and the employee will have to comply with various tax laws and regulations. As an example, a properly qualified ISO will require certain tax reporting forms to be completed by the company on an annual basis.

Ownership Issues

Before issuing equity-as-compensation, ownership and dilution issues should be fully explored and understood. As an obvious example, if your non-public company is currently owned 50%-50% by two shareholders, granting stock-as-compensation will obviously change that balance. Changing the balance possibly changes who controls the company. Of course, stocks, ownership units, and other equity can be issued in a variety of ways including common, restricted, non-voting, etc. Thus, maybe offering an employee non-voting shares resolves any ownership and dilution issues. At the same time, non-voting shares might not be desired by the employee(s).

Resale and New/Other Owner Issues

As we have discussed with respect to family businesses, small privately-held corporations generally want to restrict resale of the stocks and ownership. Such restrictions should be considered when contemplating a stock-as-compensation plan.

Compliance with Securities Laws

Stocks are “securities” within the meaning of both federal and California securities laws. Thus, any stock option plan must comply with the complex securities laws.

San Diego Business Law: Contact San Diego Corporate Law

If you are thinking about issuing equity compensation to attract and keep key employees, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard provides a full panoply of legal services for San Diego and California businesses including use of equities and ownership units as compensation. Mr. Leonard can help ensure any stock option plan complies with California laws including securities laws. Mr. Leonard has been named a “Rising Star” three years running by SuperLawyers.com and “Best of the Bar” by the San Diego Business Journal. Mr. Leonard can be reached at (858) 483-9200 or via email.