Using Equity (Stock) to Motivate Your Key Employees

The Non-Qualified Stock Option Plan

In our last issue (for a copy of Issue 91, please contact Christy Viviano at cviviano@claytoncapitalpartners.com) we met Stan Bartholomew, a 50-year old business owner who wanted to motivate his key employees while beginning to transfer them stock. After reviewing the pros and cons of an Incentive Stock Option Plan (ISO), Stan wanted an alternative.

Stan wanted the alternative to achieve the same goals (to motivate his key employees to increase the value of the company; to retain those employees through his exit from the business; to reward the employees for performing (currently and in the past) at a superior level; and to begin transferring ownership in anticipation of his physical departure from the company.

While Stan liked the idea of motivating key employees without draining company cash flow, he did not want to be bound by the statutory requirements of the Incentive Stock Option Plan so we suggested a Non-Qualified Stock Option Plan.

Under this plan, the company would grant employees an option to acquire a specific number of shares (limited to a specific time period and at a pre-determined price). Unlike the ISO, employees would be taxed (at ordinary income rates) on the difference between the Fair Market Value of stock and the exercise price at the time of the exercise. Stan's company would receive a corresponding deduction. Like the ISO, if the employee would leave, the stock would be usually redeemed by Stan's company.

On balance, the Non-Qualified Stock Option Plan potentially offers the same benefits to the company and to the employees as does the ISO, provided the company pays each employee a cash bonus at the date of exercise and the company has taxable income.

The words "cash bonus" immediately caught Stan's attention. We explained that some employers choose to "gross up" the stock bonus with cash in an amount sufficient to pay the employee's tax on the stock bonus and the cash bonus.

Let's assume that the company bonuses Employee A $40,000 in stock. If the company bonuses the employee about $17,000 in cash, Employee A will have no out-of-pocket tax costs and the company receives a tax deduction of $57,000, resulting in a tax savings of at least $17,000 (because Stan's company is an S Corporation and is in at least a 30 percent tax bracket).

Like the ISO, the Non-Qualified Stock Option plan fails to handcuff the employees during the grant period, and, if the company repurchases the stock after the exercise, it does so with after-tax dollars.

Without a cash bonus from the company, the Non-Qualified Stock Option plan was not as advantageous to Stan's employees because they would pay tax (at the ordinary income rate) at the date of exercise on the difference between the exercise price (what they paid for the stock) and the Fair Market Value of the stock.

Let's see how the two plans compare:

While we told Stan that he could mitigate this disadvantage by bonusing each
employee the amount of that employee's tax obligation, Stan was not ready for that level of generosity. He thought that an option plan in which the employee paid nothing for ownership was contrary to how he became an owner-working hard and paying taxes along the way.

Stan's next question to us was, "Isn't there something else?" There is. It is known as the Stock Bonus Plan and is the subject of the next issue of The Exit Planning Navigator®.

Subsequent issues of The Exit Planning Navigator® discuss all aspects of Exit Planning. If you have questions, please contact Kevin Short, Managing Director (kshort@claytoncapitalpartners.com).