Stock Options, Restricted Stock & Profit Interests

December 1, 2005


Daniel M. Wasser

Key Elements of Employment Compensation Arrangements

Attorneys at Franklin, Weinrib, Rudell & Vassallo, P.C. often negotiate employment contracts for business executives. Frequently there is an equity compensation element to such contracts. In some instances equity compensation is regarded as a potential bonus, but not a benefit for which cash compensation would be compromised. In others — particularly in the case of start-up ventures — equity compensation is a critical component of the employment contract and a major inducement for the executive to accept employment.

This article discusses stock options and restricted stock, well-known forms of equity compensation granted to executives in public and private companies. This article also discusses profits interests, a form of equity-based compensation utilized most frequently to incenitvize executives in private, venture capital-backed enterprises. Other types of equity compensation arrangements, such as the issuance of interests under stock bonus and stock purchase plans, stock appreciation rights and phantom stock, are beyond the scope of this article, although the considerations discussed below also are applicable to grants of such interests.

Regardless of whether an equity compensation arrangement is a minor or a critical component of an executive’s compensation package, the potential benefit of such an arrangement can be lost if it is improperly structured. Consider two examples of what can go wrong:

Example #1: Executive leaves a secure position with a major company and takes a substantial salary cut to join a start-up venture. The key inducement for Executive is the grant of restricted stock representing a 10% ownership interest in the venture. That interest vests if Executive remains with the venture for three years. The venture does well and, at the end of three years, its fair market value (based on the most recent round of equity financing) is $10 million. The good news is that Executive’s ownership interest has vested and is now worth $1 million. The bad news is that because Executive did not file an 83(b) election when he received the stock award, Executive is deemed to have received $1 million of ordinary income upon vesting and owes approximately $400,000 in taxes. But, it gets worse. Since the venture is private, there is no way for Executive to liquidate his ownership interest and generate the cash needed to cover the taxes.

Example #2: Executive has accepted a position with a large public company and has received a substantial award of stock options which vests in thirds, over three years. After 11 months, Executive’s department is reorganized and Executive’s employment is terminated without cause. During that same period, the price of company’s stock has risen 50%. However, because Executive’s tenure has been only 11 months, none of the options are vested and Executive derives no benefit from them.

To effectively negotiate the terms of equity compensation arrangements, counsel must have an in-depth understanding of the structure of such arrangements, as well as their tax impact. The following are the key features of equity awards and analysis of the issues counsel is most likely to attempt to negotiate.



A stock option gives the holder the right, for a designated period of time, to purchase shares of stock at a fixed price (referred to as the “exercise price” or ” strike price”). The option becomes valuable when the underlying stock appreciates above the exercise price, and the payoff for the executive comes from the exercise of the option, followed by the sale of the underlying stock at a price above the exercise price.

Stock options are classified as either Non-Qualified Options (“NQO’s”) or Incentive Stock Options (“ISO’s”). Certain tax advantages attach to ISO’s, but only if rules set by the IRS are followed. Options that do not qualify as ISO’s are referred to as NQO’s. An option that was intended to qualify as an ISO but fails to meet all of the requirements of the ISO rules will not become null and void; rather it will be deemed converted into a NQO.

Before issuing options, companies usually adopt a stock option plan that spells out the broad outlines of the terms on which options can be issued. For even greater flexibility, some companies adopt an equity incentive plan under which not only options, but also restricted stock and other forms of equity-based compensation, may be issued. Without a shareholder approved plan, no option may be classified as an ISO. Decisions concerning the issuance of options generally are made by the Board of Directors or, in larger companies, a compensation committee or an options committee appointed by the Board.

When a grant of options is made to an executive, that grant is made pursuant to a stock option agreement, which may be a separate document or incorporated into an employment contract. The stock option agreement will indicate whether the option is a NQO or an ISO, and will also address matters such as the vesting schedule, exercise price and term. The manner in which such matters are handled in the stock option agreement must not be inconsistent with the broad outlines of the company’s stock option plan. The plan will prevail in the event of a conflict.

Issuance of Stock Options; Exercise Price

The issuance of a stock option is not a taxable event. For the option to qualify as an ISO, the option exercise price must be at least 100% of fair market value measured as of the date the option is granted (110% if the executive holds more than 10% of the company’s shares). Although there is no requirement that the exercise price of a NQO be set at fair market value on the date of issuance, it would be difficult for the company to justify a lower price to its other stockholders. Moreover, if the exercise price were set below fair market value, there could be a charge against the company’s earnings, which could be problematic, particularly for a company looking to dress up its balance sheet for a public offering.

Determining fair market value is not generally a problem for a public company with a market for its stock. In the case of a private entity, fair market value is more difficult to ascertain and frequently is determined by reference to a recent third party financing, an appraisal or, most commonly, the good faith judgment of the Board.

Vesting Schedule

Stock options, as well as restricted stock grants and profits interests, usually are made subject to a vesting schedule designed to encourage the executive to make a long-term commitment to the company. For example, it would not be uncommon for options to vest (i.e., become exercisable) over a period of four years at the rate of 25% per year. Occasionally, the vesting of options is triggered by, or is conditioned on, the company’s achievement of certain financial results. When extended vesting schedules are combined with appreciating value, equity compensation arrangements can become “golden handcuffs.”

A key limiting factor on the issuance of ISO’s to senior executives is the requirement that the value of the shares covered by the option which can vest in any calendar year may not exceed $100,000, based on the value of the shares on the date of grant. To illustrate, if an executive were granted a fully vested option to purchase 4,000 shares at an exercise price of $80 per share, the option could not be classified as an ISO because the value of the shares exceeds $100,000 (4,000 x $80 = $320,000). However, if that option were to vest over four years at the rate of 1,000 shares per year, the option could qualify as an ISO since the value of the shares which vest in any one year is below $100,000 (i.e., 1,000 x $80 = $80,000).

Except in rare instances, vesting ceases upon termination of employment. Thus, even if the executive has certain post-termination rights to exercise an option (discussed below), under most circumstances, that right enables the executive to exercise only those options which were vested on the date of termination.

Tax Treatment Upon Exercise

In the case of a NQO, the difference between the exercise price and fair market value on the date of exercise (the “spread”) is treated as ordinary income to the executive. Thus, if the executive is granted an option with an exercise price of $15, which he exercises when the stock price is $20, the $5 spread will be considered ordinary income and taxed the same way as salary.

If an executive exercises a NQO, holds the shares issued upon exercise and the value of those shares increases, upon sale the difference between the fair market value of the shares on the date of option exercise and the sale price will be treated as a short term or long term capital gain, depending on the post-exercise holding period. To illustrate, if the stock issued in the prior example were held for 18 months and then sold at $30 per share, the executive would have $10 of long term capital gain on the appreciation following the date of exercise.

Since the spread is taxable, the holder of a NQO generally will not want to exercise the option unless, immediately following exercise, sufficient shares can be sold to generate the cash needed to pay the taxes on the spread. This is generally not a problem when options are issued by a public company, but it is a formidable problem for the executive who holds options in a private company.

The major advantage of ISO’s is that when an ISO is exercised, there is no tax on the spread. Moreover, as long as the stock underlying the option is not sold prior to the date that is at least two years from issuance of the option and one year from its exercise, the entire spread between the option exercise price and the sales price will be treated as a long term capital gain. Thus, if in the prior example the option were an ISO rather than a NQO, there would be no tax on the $5 spread. If exercise occurs one year after the option is issued and the underlying stock is sold at $30 two years after the option is issued, the entire $15 appreciation above the exercise price will be treated as a long term capital gain. Although it is beyond the scope of this article, it should be noted that the untaxed spread is taken into account in determining the applicability of the alternative minimum tax to the optionee in the year in which an ISO is exercised.

Duration of Options; Post-Employment Exercise

An ISO must be exercised within ten years following its issuance (five years if the executive holds more than 10% of the company’s shares). An ISO may be exercised by an executive only during his employment or within three months thereafter, unless the employment terminates because of death or disability, in which case exercise may take place within 12 months following termination.

Neither tax laws nor any other laws require that NQO’s be exercised within any particular period of time following their issuance or within any particular period of time following the termination of an executive’s employment. Nevertheless, it would be unusual for a NQO to have a term of greater than ten years or for the company to offer a post-termination exercise right of more than 30 to 90 days. Of course, if an executive’s employment is terminated for “cause,” the right to exercise outstanding options usually terminates immediately.


Basic Characteristics of Restricted Stock Grants

When shares of company stock are either given or sold to an executive subject to restrictions, the grant is referred to as a “restricted” stock grant. The most common and significant restriction is a prohibition on transfer (including sale) that lapses in accordance with a schedule designed to incentivize the executive to remain with the company or to achieve certain financial results. For example, an executive might receive 3,000 shares of company stock at no cost upon the commencement of employment, subject to a risk of forfeiture that lapses as to 600 shares on each anniversary of the stock issuance. Thus, if the executive’s employment were to terminate after one year but before two years of service, the executive would be entitled to retain only 600 shares; the other shares would be cancelled. Although the executive actually becomes the owner of the restricted shares on the day they are issued (subject to a risk of forfeiture), it nevertheless is common to refer to shares as “vesting” as the risk of forfeiture lapses.

Tax Treatment of Restricted Stock Grants

To analyze the tax implications of a restricted stock grant, first consider the obvious: If an executive were to receive a $100,000 signing bonus upon joining a company, the executive indisputably would have $100,000 of taxable ordinary income. The tax treatment would be the same if the executive were given $100,000 worth of readily marketable, publicly traded stock.

The IRS holds that if an executive joins a private company and receive shares with a value of $100,000 (based on the fair market value of the company), the executive will be deemed to have received $100,000 worth of ordinary taxable income, just as in the examples above, regardless of whether there is a ready market for the shares. The IRS agrees, however, that if the shares awarded to the executive are restricted (i.e., subject to a risk of forfeiture), it would be unfair to tax the executive on property he might ultimately forfeit. Accordingly, the basic rule is that restricted shares issued in connection with employment services will not be taxed until the risk of forfeiture lapses. However, when the risk of forfeiture lapses and the shares cease to be restricted, the unrestricted shares (i.e., the “vested shares”) will be taxed at their fair market value on the date of vesting, not the date of issuance.

To illustrate, assume the executive is awarded 3,000 restricted shares with a value of $30,000 which vest as to 1,000 shares each year. If, when the first 1,000 shares “vest,” the value of the 3,000 restricted shares is $60,000, the executive will be considered to have received $20,000 of ordinary income, i.e., the current market value of the 1,000 shares on the vesting date. No tax would yet be due on the 2,000 unvested shares. If the company’s shares were to continue to increase in value over the next two years, the value of the second and third groups of 1,000 shares — and consequently the associated tax liabilities — also would increase.

The 83(b) Election

Section 83(b) of the Internal Revenue Code gives the executive who receives restricted stock for services an alternative tax approach compared to the basic rule discussed above. Within 30 days following the issuance of restricted shares, the taxpayer has the right to file what is known as an “83(b) election.” By filing the election, the executive declares his intention to recognize as ordinary income the difference between the fair market value of the restricted shares issued to him and the purchase price (if any) paid by him, even though he may forfeit some or all of the shares. If the executive ultimately forfeits shares, there is no tax refund or tax credit for the taxes paid; nor is there any tax adjustment if the shares decline in value. However, there are meaningful potential benefits. First, if the restricted shares increase in value, the executive does not pay tax on the increased value when they vest. Second, by filing the 83(b) election and paying taxes up front, the executive commences a holding period in the shares. Consequently, when the executive sells the formerly restricted shares at a price above the price attributed to the shares on the date of issuance, the gain will be taxed as a capital gain (either short term or long term depending on the holding period) rather than as ordinary income.

If an executive joins a private company and receives a restricted stock grant, it often is advisable to file an 83(b) election, assuming the executive anticipates an increase in the value of the company. An executive in a private company who fails to file an 83(b) election after receiving restricted stock could be liable for substantial tax liabilities if the stock appreciates; moreover — and compounding the problem — the executive will generally have no way to sell private company shares to generate the cash with which to pay the taxes.

If a public company issues restricted stock pursuant to a plan which enables the executive to readily sell the shares once the risk of forfeiture lapses, different considerations apply. Under such circumstances, an executive might very well elect not to file an 83(b) election. Rather, upon vesting, the executive would sell such number of shares as may be necessary to cover the tax liability resulting from vesting. By not filing an 83(b) election, the executive will have lost the opportunity to have his gain on the restricted stock treated as a capital gain; however, the executive will have avoided the risk of paying taxes on stock he might forfeit or that might not result in a financial benefit to him.

If the decision is made to file an 83(b) election, it is critically important that the filing be made within 30 days after the shares are issued. It is a simple form, but if not timely filed, the right to make the election irrevocably is lost. On the other hand, once it is filed, the election is irrevocable and cannot be undone.

The filing of an 83(b) election has no negative impact on the company. However, it is important that the executive and the company agree on the value to be ascribed to the restricted shares to insure that the executive’s tax filing is not inconsistent with the W-2 issued by the company to report the compensation paid to the executive in the form of restricted stock.

It is often — and incorrectly — assumed that if an executive pays fair value for restricted shares, an 83(b) election need not be filed. In a start-up company, as part of his employment compensation package, an executive might receive a large grant of restricted shares for which the executive might pay the minimal value ascribed to the shares at that nascent stage. Since the executive paid fair value for the shares, no tax is due. However, because in this example the shares were issued as part of his employment package and are subject to a risk of forfeiture, unless an 83(b) election is timely filed, the executive will be taxed on increases in value as the shares vest.


Basic Characteristics of Profits Interests

A profits interest is an interest in a partnership that would not give the holder of the profits interest a share of liquidation proceeds if the partnership were liquidated immediately after the issuance of the profits interest. In 1993, the IRS confirmed that the receipt of a partnership profits interest in consideration for services would not be considered a taxable event (since if the partnership were dissolved immediately after the profits interest were granted, the holder of the profits interest would receive nothing). In 2001, in Revenue Procedure 2001-43, the IRS confirmed that if an executive is granted a non-vested profits interest in consideration for performing services and is treated as the owner of an interest in the partnership from the date of grant (i.e., the partnership allocates to the executive, and the executive takes into account in computing his income tax liability, the distributive share of partnership income, loss, deduction and credit associated with the full profits interests, whether or not vested), then neither the initial receipt nor the subsequent vesting of such profits interest will be considered a taxable event. Although certain tax practitioners would suggest that there may be some benefit to the executive in filing an 83(b) election with regard to the receipt of a non-vested profits interest, the IRS does not require such a filing (which contrasts with the requirements applicable to non-vested grants of employment-related restricted stock, where the filing of an 83(b) election is a necessary precondition to the non-recognition of income upon vesting). The tax treatment of profits interests in partnerships also applies to profits interests in limited liability companies taxed as partnerships.



In negotiating an equity compensation arrangement, whether in the form of stock options, restricted stock or profits interests, the vesting schedule is often a subject of intense negotiation. The negotiations are not limited to the vesting schedule itself (e.g., will the interest vest annually or monthly and over how long a period of time). The most intense negotiations often concern the circumstances under which the vesting schedule accelerates.

Counsel will argue that vesting should accelerate if the executive’s employment is terminated without cause, since the executive otherwise will be deprived of a valuable benefit despite his performance of his obligations and willingness to continue to do so through the vesting period. Counsel might also contend that if the executive is unable to perform due to death or disability, the executive should not be deprived of the benefit of the equity award. Particularly when the employer is a private company, there often are discussions regarding accelerated vesting in the event of a change of control or completion of an initial public offering.

Post-Termination Exercise of Stock Options

Even if counsel achieves favorable acceleration provisions, the executive’s post-termination right to exercise stock options must be considered in connection with NQO’s. (As noted above, in the case of ISO’s, the post-termination right to exercise is dictated by the Internal Revenue Code.) Assuming termination is not for “cause” — in which event there would generally be no post-termination right of exercise — companies generally offer no more than a 30 to 90-day post-termination window for exercise, but will not object to extending that period (usually for up to one year) if employment terminates due to death or disability.

In the case of a public company, as long as the options can be readily exercised with a simultaneous sale of the stock, a relatively short window is not problematic as long as the options are “in the money,” i.e., if the market price is above the strike price. If, however, the options are not “in the money,” it would be advantageous to the executive to hold the options for as long as possible in the hope that they will increase in value. Thus, counsel might attempt to negotiate a longer post-termination exercise right, although such a right is unlikely to be granted by a public company except to its most senior executives.

Ironically, the more “in the money” the options are, the greater the dilemma for the executive holding options in a private company. The problem is that ordinary income tax must be paid on the spread but, because the company is not public, there is no market for the shares and, therefore, the executive is unable to sell shares to raise funds to pay the taxes. The executive must now decide whether he is willing to reach into his savings to pay taxes on the spread and then hold the shares for an indefinite period (and subject to possible declines in value) until they can be sold. Unless the executive has the financial resources necessary to bear the tax cost and is willing to live with the risk that the value of the shares will decline, the requirement that the option be exercised within a relatively brief period following termination can vitiate the entire value of the options. For this reason, counsel will endeavor to negotiate the longest possible post-term exercise period for an executive holding private company options.


Since equity interests often are granted in connection with start up ventures, there often is considerable latitude for negotiation. When equity interests are offered in more seasoned enterprises, counsel’s suggestions for improved terms with respect to vesting and, in the case of options, post-termination exercise, often will be met with a response that “these are the company’s standard terms, and no changes are possible” or that “these are the terms required by the plan.” In fact, however, stock option and equity incentive plans usually give the Board a significant degree of authority to customize the terms of individual grants. For example, although the company generally may grant options which vest at the rate of 25% per year, the governing plan typically would contain one of two provisions: either a very general delegation of authority such as, “Options will vest at such rate as is determined by the Board;” or a more specific, but still flexible, delegation of authority such as, “Options will vest at the rate of 25% per year, unless the Board otherwise determines.”

As always is the case, negotiating success is a combination of numerous factors, including leverage, strategy and knowledge. Familiarity with the intricacies of the matters discussed in this article does not insure that the company will readily grant requested accommodations. However, given the wealth-creation potential of equity compensation arrangements, it is critically important that those arrangements be negotiated vigorously by counsel with a thorough understanding of the issues.