CFO Corner – Non-Qualified Stock Options Are Much Better Than They Sound

Dan Walter, Performensation

Non-Qualified
Stock Options (NQSOs, NQs, NSOs) should really be called Stock Options.
Non-qualified (or non-statutory) makes them sound negative. The negative
modifier simply refers to the fact that these stock options have no special
section dedicated to them in the IRS tax code. Like Incentive
Stock Options (ISOs),
NQSOs are generally appreciation-only instruments. Unlike like ISOs, if the
plan and local rules allow, they can be granted at price less than Fair Market
Value (FMV). Although ISOs get most of the press, NQSOs are more commonly
granted.

While
ISOs are a common start-up tool, NQSOs are often preferred by established
companies precisely because of the their lack of special tax treatment. Because
all NQSOs granted to US employees will eventually result in ordinary income and
the associated tax withholding, finance departments can plan for the future tax
event by accounting for a Deferred Tax Asset (DTA). These stock options are
easier to administer since there is seldom a need for post-exercise tracking,
calculations of maximum limits or adherence to some of the other specific rules
governing ISOs. NQSOs are also far less restrictive in their granting rules
than ISOs.

Companies
can easily grant NQSOs to non-employees including Directors and contractors.
Plans must be properly designed to allow this and the provisions are simple to
implement. This makes NQSOs very flexible. In fact, every company that grants
ISOs must also be able to grant NQSOs by default. ISOs over the $100,000 limit
are treated as NQSOs. ISOs that remain outstanding beyond prescribed
post-termination grace periods must be treated as NQSOs. Any stock option in
the US that isn’t an ISO is a NQSO.

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NQSOs
can also allow for some tax planning opportunities. Plans can be designed to
allow participants to exercise unvested options. This is sometimes called early
exercise, or exercise before vest. For NQSOs, ordinary income is realized only
after the options are both exercised and no longer “subject to a significant
risk of forfeiture.” Early exercises can allow an optionee to exercise when the
difference between the exercise price and fair market value of the underlying
stock is low (quite often $0.00.) The individual can then file an 83(b)
election, effectively moving the date of ordinary income measurement to a
period where there may be little or no income to be taxed. This strategy can be
dangerous if the spread is significant at exercise and lower on the vesting
date. Participants may not be possible to recoup the losses in a reasonable
timeframe.

NQSOs
should be included in any equity compensation program. They must be used with a
full understanding of their strengths and weaknesses. Like any stock option the
intent is to focus participants on increasing the company’s stock price. These
options may deliver far more compensation than a company has to expense. However,
they can also fall underwater and deliver nothing to the participants, while
the company cannot reverse the associated expense. When values are high they
can be exciting and rewarding. When the participant can’t realize value, NQSOs
can be demotivating and create discontent. Companies must calculate and
withhold taxes at the time of exercise. This provision means that companies can
amortize a DTA for expected exercises. Lastly, like any stock option, their
upside can make up for other compensation shortcomings. This, of course, can be
a double-edged sword that can inflate pay when the stock price shoots skyward.

NQSOs
can be structured to meet fairly short (1-2 years) and very long (25 years is
not unheard of) timeframes. Proper plan design, communication and
administration are essential to the success of a NQSO program. They are a
flexible tool that can allow both companies and participants to take advantage
of stock price growth at a fairly low cost.

This
is part of a series of posts on equity compensation instruments that will run
the first Thursday of every month for the foreseeable future.  Please reach out to me directly if you have
any questions.

Dan Walter is the President and CEO of Performensation an
independent compensation consultant focused on the needs of small and mid-sized
public and private companies. Dan’s unique perspective and expertise includes
equity compensation, executive compensation, performance-based pay and talent
management issues. Dan is a co-author of “The Decision Makers Guide to Equity Compensation”, “If I’d Only Know That”, “GEOnomics 2011” and “Equity Alternatives.”
Dan is on the board of the National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the
founder of Equity Compensation Experts, a free networking group. Dan is frequently requested as a
dynamic and humorous speaker covering compensation and motivation topics.
Connect with him on LinkedIn or follow
him on Twitter at @Performensation and @SayOnPay