Compensating employees with nonemployer stock options.

• Author: Trainer, Corina

Many companies routinely include nonqualified stock options (NQSOs) in compensation packages for their executives and, because of the competitive labor market, for certain other employees. An NQSO gives the employee the right to purchase a set number of shares of employer stock, generally after a vesting period, at a specified price for a specified period. The exercise price typically is the stock's fair market value (FMV) on the day the option is granted.

Programs providing stock options in the employer are popular for several reasons. Companies like option programs because they offer a powerful financial incentive to employees without expending cash. Shareholders like option programs because they believe the programs align executive interests with those of the company and shareholders. Employees view option programs favorably because they permit them to control the timing of income recognition and benefit from any appreciation in the market value of the underlying stock without an initial investment of funds.

There are situations, however, in which traditional option programs do not meet the objectives of a company, its shareholders or employees. If an employee already holds a significant number of options or a large amount of stock, granting additional options will no longer align the employee's interest with the company's and the shareholders'. In these circumstances, furthering the employee's desire for a diversified portfolio may instill greater employee satisfaction and provide the employer with a more powerful compensatory tool. Similarly, when the employer's stock appreciates slowly, it may lack the appeal necessary to attract and retain highly qualified employees in a competitive labor market. Finally, there may be times when there are insufficient shares available on which to grant options because of shareholder sensitivity to further stock dilution.

In these circumstances, companies may create a nonemployer stock option program (nonemployer SOP) and grant options to selected employees to purchase the stock of other companies. Like a NQSO program, a nonemployer SOP offers the employer considerable flexibility, including the ability to set the terms of the option and any vesting requirements. Similarly, the options may be offered at a discount price (although there is no requirement that discounts be offered). Employers also may maximize the incentive value of options in a nonemployer SOP by choosing stocks related to the...