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Sweet marketing music

Tanner Montague came to town from Seattle having never owned his own music venue before. He’s a musician himself, so he has a pretty good sense of good music, but he also wandered into a crowded music scene filled with concert venues large and small.But the owner of Green Room thinks he found a void in the market. It’s lacking, he says, in places serving between 200 and 500 people, a sweet spot he thinks could be a draw for both some national acts not quite big enough yet for arena gigs and local acts looking for a launching pad.“I felt that size would do well in the city to offer more options,” he says. “My goal was to A, bring another option for national acts but then, B, have a great spot for local bands to start.”Right or wrong, something seems to be working, he says. He’s got a full calendar of concerts booked out several months. How did he, as a newcomer to the market in an industry filled with competition, get the attention of the local concertgoer?

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by Daniel Tenenbaum
April 2004

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Law

business builder law  

Stock options still
provide incentives
yet preserve cash

Now that large companies like Microsoft have announced plans to scrap their stock option plans, other companies may be tempted to follow their lead toward alternative employee incentive programs, such as restricted stock grants.

But not so fast. Stock option plans can be an attractive way for smaller, growing, private companies to create equity-based incentive for employees without significantly affecting their cash flow.  Since cash is king in an early-stage growing enterprise, stock option plans can be a powerful tool for creating incentive to those in a position to make a difference.

The lingo around stock options can be one of the most confusing aspects of adopting and implementing a plan. There are basically two types of options:  qualified options, which are also sometimes called “statutory” and are defined under the internal revenue code as “incentive” stock options (ISO); and non-qualified options, which are sometimes referred to as “non-statutory”.

Keep in mind as you consult with your advisers that this terminology has specific meaning. Many businesses use “incentive stock options” in the generic sense only to learn that their attorneys and accountants presume they mean the type of option defined in the internal revenue code.

Qualified options, which need to meet certain requirements under the internal revenue code, have special tax benefits. There is no income tax event on the exercise of the option, although there may be an alternative minimum tax so an optionee should still consult a tax adviser.

This can be especially important when an option is being exercised but the underlying stock is not immediately saleable because of securities laws or other limitations.  If an employee exercises a qualified stock option and receives stock that is not freely tradeable, he or she is not required to cover any income tax burden without a mechanism to trade the stock and create liquidity. The income tax realization event comes at the later time when the individual sells the stock acquired by exercising the option, presumably when there will be cash to cover the burden.

While there are a number of requirements for granting qualified options, the most significant are that qualified option grants:

• Can only be granted to employees (not consultants or independent contractors);

• Must have an exercise price at least equal to fair market value on the date of grant;

• Are inherently tied to employment (they must be exercised within 90 days of the termination of employment);

•  Are limited to a maximum annual vesting of $100,000 worth of stock (number of shares times exercise price) during any single calendar year.

In order to grant qualified options, the stock option plan must be approved by the shareholders of the company within 12 months from its adoption.  There are additional limitations that apply to shareholders who own more than 10 percent of the outstanding shares.

Non-qualified options are not regulated under the internal revenue code, which has both positive and negative ramifications. On the upside, there is much more flexibility on the parameters of these options.

There are no specific limitations on issues such as maximum grants, who can be a grantee, and what the exercise price must be, although many plans limit exercise price to not less than 85 percent of fair market value for a variety of reasons, including potential future securities laws complications.  The bad news is that there is an income tax recognition event on exercise of the option. The optionee owes tax on the difference between the exercise price and the fair market value on the date of exercise.

This can be very significant, especially where immediate liquidity in the shares is absent.  For example, if you were to exercise a non-qualified option to purchase 50,000 shares at $1 per share at a time when the fair market value of a share is $10, you would have immediate taxable income of $450,000 ($9 x 50,000).  The optionee could end up owing the IRS tax on this gain. If the shares can’t be sold because they aren’t freely tradable or there is no public market for them, the optionee might not be able to afford it.

Weighty matters
In implementing a stock option plan, a company should carefully consider its desired objectives.  It is important that people being granted options understand what their rights are and, more importantly, the potential future value of the option if everyone does his or her part to increase the value of the business.

While your legal adviser will caution you against making any promises about the future value of the option, it is often instructive to provide an example of the value of the option at future dates, assuming a future value of the business that isn’t outside the realm of possibility.

Companies sometimes make the mistake of granting options to employees at all levels of the organization, without making sure that individuals at all levels understand the potential benefits.  At the opposite extreme, some businesses limit option grants only to the executive management team, which can have the unintended consequence of further dividing a work force.  It can also fail to provide incentive and reward for all in the organization who can make a meaningful impact on the bottom line.

Finally, make sure that the total option plan and the types of grants you are making are consistent both with your organization’s development stage (as the risk goes down, so should the number of options being granted) and for your industry.  It is important to also ensure that your option “overhang” (the ratio of options to outstanding stock) isn’t so great as to make future equity financing activity more difficult, more expensive, or impossible to complete.

Having a large percentage of options outstanding (many consider 20 percent to be a normal ceiling) may make your business look unusual to potential investors.  In addition, most future financing sources use a “fully diluted” calculation, which will take into account all outstanding options as if they were exercised, which may make it difficult to reach agreement on business valuation.

Accounting rules and downturns in the public market may have led some to conclude that option grants are not an appropriate incentive tool. However, they should still be viewed by growing businesses as a viable way to create incentives for individuals who can make a difference without costing an enterprise scarce cash resources.

Daniel Tenenbaum is a principal at Gray Plant Mooty in Minneapolis who works with emerging growth companies: 612.632.3050;  dan.tenenbaum@gpmlaw.com