Many entrepreneurs, especially those who are new to running a business, often find themselves low on cash reserves while desiring to retain the services of industry experts. When a business owner does not have cash to pay for services, a useful alternative is to offer equity instead. While exchanging equity in lieu of cash can be a wise, necessary business decision, it does come with its risks. When one purchases equity in a company, she is entering into a relationship that binds her to the company and can grant her certain rights as a shareholder.
This type of arrangement can be mutually beneficial, but business owners are rightfully reluctant to offer equity to an outside professional without having an opportunity to test whether the expert is a good fit for the business. Likewise, an expert may not want to be tied to a company before first seeing its inner workings for herself. But stock options—specifically non-qualified stock options—can assuage the concerns of both parties and offer a great solution for the business owner and expert advisor.
Generally speaking, an option is the right to buy or sell a security or other asset at an agreed-upon fixed price. A non-qualified stock option (“NQSO”) gives the holder of the option the right to purchase shares in a company at a fixed price, usually for a specified period of time. In exchange, instead of cash, the party receiving the option can offer services to the issuer of the option (the company). If the option-holder believes the value of the business is bound to increase, or the stock price does in fact go up, she can buy the stock at the fixed-price and reap the difference in profit.
For example, Smith & Assoc. engage Ms. Johnson to work in an advisory capacity. In exchange for agreeing to provide advising services on a part-time basis, Ms. Johnson receives the right to purchase up to 50,000 shares in Smith & Assoc. at a fixed-price of $0.10 per share. If Ms. Johnson believes the stock price will increase or actually sees the price increase, Ms. Johnson can exercise her right to purchase the Smith & Assoc. shares at $0.10 per share and enjoy the profit.
While this arrangement is at the core of the relationship between the parties, there are additional restrictions and limitations involved that are designed to protect the interests of both parties.
The primary concern for a business owner offering equity is that the holder of the option might exercise her purchasing rights and then quit providing services. To mitigate this possibility, non-qualified stock options are made subject to certain “vesting” periods during which time the option holder’s right to purchase stock accrues. Typically, option holder will not have the right to purchase stock for a certain period of time, after which the amount of stock she may purchase will accrue in increments, up to the maximum amount under the option contract.
In our example above, it would not benefit the company to allow Ms. Johnson to purchase any shares in Smith & Assoc. on the first day she began providing services; rather, the option contract would ideally be crafted to allow Ms. Johnson to purchase equity only after advising Smith & Assoc. for a substantial period of time. Additionally, even when Ms. Johnson gains the right to purchase stock, she might only be able to buy a small percentage of the 50,000 shares contemplated by the agreement. Although each company’s needs will differ, in this example, the parties could agree that Ms. Johnson be permitted to purchase 5% of the total shares after the first six months, and then each month after that up to 5% more, so after 20 months she would be “fully vested” and able to buy up to 50,000 shares at the fixed price of $0.10 per share.
Vesting allows an entrepreneur to vet an expert before giving up equity in her business. If the relationship appears to be mutually beneficial, the business owner should be happy to exchange equity for the value that the expert advisor brings to her business. In the end, the exact vesting schedule is a major point of negotiation, and the exact terms will depend on the circumstances of each party.
When an option holder decides to exercise her rights to purchase shares, she must also be careful to consider the tax consequences. The difference in option purchase price and the stock price when the option is exercised generates income on which taxes must be paid. For example, if Ms. Johnson purchases 50,000 shares at $.10 per share but the value of the shares increases to $.50 per share, she will have paid $5,000 for shares worth $25,000. The difference, $20,000, is generally treated as taxable income. Of course, any further increases in stock price after exercising the option could also be subject to long-term capital gain taxes.
Because of these tax consequences, the party exercising the option will need to plan ahead to make sure she has enough cash to cover the taxes she will owe. While this is primarily a concern for the receiver of the option, it might also be a point for negotiation. All individuals considering such financial transactions should obtain advise from a well-qualified tax advisor to understand the full consequences.
Overall, offering non-qualified stock options in exchange for expert services can be a great tool for the entrepreneur, especially one whose cash flow is limited. While this article is intended to provide a basic introduction to non-qualified stock options, it does not cover every facet of non-qualified stock options and is not to be construed as legal advice. As with any major business decision, owners are best advised to speak with an attorney to make sure their needs and obligations are being fulfilled, and to review other potential provision to include in a stock purchase agreement. To consult with one of our attorneys, please contact us here.
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