What is a stock option?

A stock option is a contract that gives a person the ability to purchase stock at a later date for a specified price. Typically these are used in investment or incentive scenarios as a way to allow the optionee to take advantage of any upside the company faces without having to invest when the option is granted. Stock options are used significantly in the entrepreneurial community for investors, owners and employees.

Stock options come in all shapes and sizes. There are statutory stock options and nonstatutory stock options. They can include a vesting schedule, lock up provisions, rights of first refusal, and many other restrictions. Which restrictions are used is a matter of personal preference and dependent on the specific situation.

A stock option agreement requires only a few things. First, it will need the number of shares the person will have access to, when he or she will be able to exercise the option, what restrictions prevent her from exercising, when the option expires and the cost to exercise. Typically, the cost must be the fair market value or higher at the time the grant was issued. If it is lower, the optionee may be subject to income tax consequences that she would not want.

If stock options are granted to an individual who does not also work for the company, there may be SEC filing requirements. It is important to ensure that there is either an exemption or that the filing requirements are met for each exchange of stock or stock options. The penalties for failing to comply are steep.

When creating or reviewing your own stock option agreements, make sure that there are no circumstances where they can be arbitrarily cancelled/terminated, nor are their opportunities where the optionee can not uphold her side of the bargain and yet receive the stocks.

Typically, there are four ways a person can exercise the options: (1) cash, (2) cash equivalent such as check, money order, etc, (3) property approved by the company, or (4) by forfeiting an amount of shares whose profit would match the exercise price of the remaining shares.

For example, if you have 10,000 options that you can exercise at $10 a piece and are now worth $50, you can redeem your options by forfeiting 2,000 of the shares and keeping the other 8,000. There would be no cash exchanged, and the 2,000 shares would return to the company’s stock option pool or whatever allocation they may have under the company’s stock plan.

Stock options are generally only available for corporations. Limited Liability Companies, Partnerships and other similar companies do not have stock, but can create similar devices with more advanced agreements.

If you have any questions or would like to set up or review your stock option plan, please contact Richard Bobholz at richard@lawplusplus.com or by calling 919-912-9640.

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