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NOVEMBER 25, 1999

SMART ANSWERS
By Karen E. Klein

The Options Option: How Private Companies Can Use Stock as an Incentive
Part one of a two-part answer on giving employees equity


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Q: I own a thriving Web business and would like the employees to share some equity in the company. We're small and have no intention of selling or going public in the near future. Yet I've been hearing a lot about the advantages of stock options. Can you give me some guidance?

---- B.B., Gardiner, Mont.

A: Intense competition for talent in a tight labor market is pushing privately held companies to give equity to the rank-and-file like never before. In the past few years, 6 million to 12 million U.S. employees have gotten stock options, most of them middle managers, not senior execs.

Stock options are a key part of compensation in high-tech startups that plan to go public quickly. But even companies that plan to remain private can use equity to reward and retain employees. First, a definition: Stock options are securities that give the holder the right to buy a certain number of shares at a given price over a given period of time. After employees exercise their options to buy stock, they can hold it or sell it immediately, pocketing any premium over the exercise price. With publicly traded companies, the market determines the value of a company's shares. Private-company owners must revalue their businesses periodically and make provisions to buy back shares at fair-market value if employees want to sell them.

You can offer stock options to as many — or as few — employees as you choose. Their advantage is that they cost employees nothing in taxes until they exercise them. "They're somewhat of a win-win — relatively cheap and effective as a retention tool...as long as the stock's going up," says Ed Lawler, a University of Southern California business professor and author of an upcoming book, Rewarding Excellence, on employee retention.

According to the National Center for Employee Ownership, a nonprofit organization based in Oakland, Calif., companies can issue options in several forms. Here are two of the most common, with some of the tax issues they raise:

Incentive stock options (ISOs): ISOs present distinct tax benefits for employees — more than for companies, which can't deduct the value of ISOs they distribute from corporate taxes. The major tax advantage to employees is that they don't pay taxes until they sell shares. And if employees hold their shares for two years after the options are granted, any gain is taxed at the lower capital-gains rate, rather than the ordinary-income rate. (Generally, the federal government taxes capital gains on securities held for less than one year at ordinary income-tax rates, which range from 28% to 39% for most people. Capital gains on securities held one year or longer are taxed at 20%.)

Nonqualified stock options (NSOs): Under this format, most of the tax benefits accrue to the company not the employees. The company receives a tax deduction based on the difference between the option exercise price and the shares' market value when the options are exercised. When employees exercise their options, they pay tax at the ordinary income rate on the premium in value over the exercise price, whether they sell the stock or not. If employees hold the stock for over a year instead of selling it immediately, any additional rise in value is taxed at the capital-gains rate, not as ordinary income. Most broad-based stock option plans use NSOs, according to the NCEO, because they are simpler to administer than ISOs.

Any stock-option plan involves myriad tax and securities considerations and requires experienced professional advice. Contact compensation consultants and attorneys who specialize in privately held companies. "Be careful when you're looking for a professional to handle this, because most advisers will tell you they've done a lot of this and only a relatively small number actually have," says Corey Rosen, the NCEO's executive director. "Ask them to give you a list of actual clients they've put these plans in place for, and make sure they are willing to let you talk to them. It's very, very important not to just stick with your regular lawyer for this. It's a specialized legal area and requires special expertise."

You'll also need a professional business valuation so you can establish a price for your shares. These are usually done by business brokers or financial analysts who specialize in valuations for stock-purchase plans or initial public offerings. You can also reprice your stock based on your company's book value as calculated by your accountant. The law doesn't say how a private company must price its shares — except that they must be at fair-market value. The problem is that book value is rarely accurate. If you overvalue your stock, you'll end up paying too much for shares that your employees present for redemption.



Have a question about running your business? Ask our small-business experts. Send us an e-mail at smartanswers@businessweek.com, or write to Smart Answers, BW Online, 6th Floor, 2 Penn Plaza, New York, NY 10121. Please include your real name and phone number in case we need more information; only your initials and city will be printed. Because of the volume of mail, we won't be able to respond to all questions personally.

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