The Stock Option Agreement gives a service provider (an employee or a consultant) the right to purchase a specified number of shares of your startup’s Common Stock at a set price for a defined period.
The Stock Option Agreement generated by SmackDocs includes the following phrases:
Your startup has the choice of granting either incentive stock options (ISOs) or nonqualified stock options (NSOs). The primary difference between incentive stock options and nonqualified stock options is in the way that they are taxed (see table below).
|Stock Option Grant:||No tax consequences at the time of grant.||No tax consequences at the time of grant.|
|Stock Option Exercise:||No ordinary income realized on the “spread” when the stock options are exercised. The spread is the difference between the exercise price (specified when the stock options are issued) and fair market value of the shares on the date that the options are exercised. The spread may count toward the alternative minimum tax (AMT), but only if the recipient of the stock options is subject to the AMT in the year that the stock options are exercised.||Ordinary income is realized on the “spread” (the difference between the exercise price of the stock options and fair market value of the shares on the date that the stock options are exercised). If the recipient of the stock options is or was an employee of your startup, he or she must pay whatever tax withholding your startup is legally required to collect (on the spread) when the stock options are exercised. If the recipient of the stock options is a consultant or advisor, the spread should be reported as ordinary income on the Form 1099 that your startup issues to him or her at the end of the applicable year (the year in which the stock options are exercised).|
|Sale of Common Stock:||Either long or short-term capital gains on the entire “spread” when the shares of Common Stock (underlying the stock option) are sold. The spread is the difference between the exercise price of the stock options (determined when the stock options are issued) and the sale price of the shares of Common Stock.
For the capital gains to be treated as long-term, the shares of Common Stock underlying the stock option cannot be sold before (the later of): (a) two years from the date the stock option was granted or (b) one year from the date on which the recipient exercised the stock option.
|Either long or short-term capital gains on the entire “spread” when the shares of Common Stock (underlying the stock option) are sold. The spread is the difference between the fair market value of the Common Stock (underlying the stock option) on the date that the options are exercised and the sale price of the shares of Common Stock.
For the capital gains to be treated as long-term, the recipient of the stock options must hold his or her shares for at least one year from the date on which the recipient exercised the stock option.
Under IRS regulations, only your startup’s employees are eligible to receive ISOs. On the other hand, NSOs are available to employees and to other categories of service providers (such as consultants, advisors, and directors). Your startup’s board of directors should determine whether the recipient of stock options will be granted an ISO or an NSO.
Under the IRS Code, only $100,000 of ISO value is exercisable in any calendar year (e.g., as a result of vesting). Suppose then that the ISO value exceeds $100,000 in a given year – how will this be addressed? In such situations, the portion of the stock options above the $100,000 limit will be treated as a NSO. Value of an ISO is calculated by multiplying the number of shares that will become exercisable in the applicable calendar year by the exercise price per share (for purposes of this calculation, the Common Stock’s current fair market value is irrelevant). For example, if 100,000 shares under a stock option vest and become exercisable in a calendar year and the stock option has an exercise price of $2 per share (making total value of the exercised options $200,000), fifty thousand of the shares will be deemed ISOs, and the remaining 50,000 shares NSOs. Except in the case of death or disability to the holder of the stock option, incentive stock options or ISOs must be exercised within three months of such holder’s termination (of employment) by your startup. Even if the startup itself consents to a longer period for the exercising of an ISO, the stock options will be treated as a NSO if the three-month interval has elapsed.
If an employee holds more than 10% of your startup’s stock (not counting unexercised stock options) when an ISO is granted, the exercise price must be 110% of (fair market) value of the shares of Common Stock on the date the stock options were awarded. In this scenario, the stock option term is restricted to 5 years (cannot be the normal 10 years).
The stock-options recipient may pay his or her exercise price with cash (by check or wire transfer), or with shares of your startup’s Common Stock. If the recipient wants to pay the exercise price with shares of Common Stock, your startup must withhold however many shares of Common Stock have a fair market value equal to the aggregate exercise price.
Stock options are not transferable except by a few exceptions, chief among them the death or disability of the recipient of the stock option.