Start-Up Stock Options
Start-up companies are small in assets but big on dreams. For most new employees, start-ups offer options in lieu of a large salary and benefits package. With rapid growth, these stock options can be worth more than the salary the employee would have received. This serves to create a nice incentive for the whole team. However, there are many financial and legal consequences of issuing stock options.
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Options to Motivate
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Options are generally used as a motivational tool for employees. They are typically issued at a low valuation, allowing the employee to grow wealthier along with the company. They represent a real interest in the company that is taken into account at a sale or initial public offering. One famous example is the original masseuse for Google Corporation. Instead of receiving a high hourly wage, she accepted a few stock options. The resulting explosive growth in the company allowed her to exchange those options for millions a few years later.
Accounting Implications of Options
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Issuing new stock options at below market value is counted directly against earnings as they are a cost to the business. While these are a non-cash expense they can have very large real value in the future. Assigning options a historical, lower value date is called "backdating" and is illegal because it is claiming equity from current investors by mispricing the options. If the options are issued at the market value, than neither the employee nor the company records income or expense until the market value changes.
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Financial Implications of Options
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Issuing stock options by definition alters the capital structure of your firm. If you are the founding partner or venture capitalist, be careful about how many options are issued and at what price. Upon a sale (sometimes called a liquidity event in legal jargon), all of the options become common stock and are sold to the buyer. However, these are taxed as income in this situation. If you anticipate a sale, you can purchase the options directly at the prevailing value and be taxed at the much lower capital gains rate. This requires using your own capital and taking some risk though.
Legal Implications of Stock Options
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As mentioned earlier, manipulation of stock options is illegal. Retroactively changing the dates or granting more options than originally stated is a form of theft from the company. In recent years large companies including Dell and Apple have been ensnared the investigation about stock option manipulation. Lawyers should also be concerned about the risks of full-disclosure and insider trading. If the company does not disclose all material information and senior executives sell or issue new options, there could be subsequent lawsuits or SEC action against the company.
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References
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