Can You Offer Stock Options to Contractors?
Some companies choose to offer stock options to independent contractors as a form of compensation. In these situations, the contractor has the opportunity to own company shares.
This practice is most often seen in startups, as they don’t have the same access to significant amounts of money as bigger companies do, or private companies that have intentions to be publicly traded in the future.
There are a few things to contemplate when considering offering stock options to contractors, though.
Stock options and why companies offer stock to contractors
There is a difference between owning company shares and owning stock options.
- If someone owned company shares, they would own a part of and therefore have equity in that company. That person would receive dividends when the company makes profits.
- Stock options are not only the right, but the chance to purchase company shares at a set price (the strike/grant price). When a person exercises their stock options, they will own company shares, but the unique thing about stock options is that the person offered them never has to buy the stocks.
Companies can offer stock options to contractors for many reasons:
- As an extra incentive alongside a salary that’s already attractive
- As a form of compensation because the company doesn’t have that much money (yet)
- As a reward
- To garner loyalty from the contractor, as owning stocks would mean they have personal interest in the success of the company
Stock option grants will have details such as the number of shares received, type of stocks, strike price, and vesting schedule.
Vesting is a process where a person acquires the right to buy their stock options, and means that companies can have requirements before the contractor can vest their stock options, i.e. actually purchase the company shares.
If the contractor leaves the company before their stock options have the chance to become vested, then ownership of the stock options belong to the company again, so vesting is an excellent retention tool.
Different types of stock
There are two main types of stock options:
Incentive stock options (ISO)
- Eligibility: employees
- Tax treatment at exercise date: not generally taxable, but the amount between exercise price and fair market value is an AMT adjustment.
- Tax treatment at sale date: the difference between sale price and original exercise price (if held for more than one year) is taxed at long-term capital gains rate.
- Transferability: non-transferable except in the event of the recipient’s death.
Non-qualified stock options (NQSO or NSO)
- Eligibility: employees, advisors, consultants, contractors, directors, officers.
- Tax treatment at exercise date: normal income tax applies to the difference between fair market value and exercise price of the shares.
- Tax treatment at sale date: capital gains rate is applied to the difference between sale price and fair market value on the exercise date.
- Transferability: normally, NQSOs are transferable to family members, charities, or trusts for the person’s benefit during their lifetime.
Important NQSO concepts
- This is the date on which the company makes the stock options available to the contractor.
- The date on which the contractor has met all the requirements necessary to purchase their stock options; the date on which the contractor earns the right to purchase their stock options.
- Also known as the grant price, this is the price stated/specified in the employee stock option plan that the stock can be purchased at. Contractors can actually acquire their stock at a discounted price if the market prices at the time they wish to purchase the stock are lower than their grant/exercise price.
- The date on which the NQSOs will expire.
The benefits and risks of stock options for contractors
Contractors feel connected to the business
- Having ownership of a part of the company that they are contracted to do work for makes contractors feel like they are connected to the business, its employees, and its success.
Financial rewards from a successful business
- Of course, owning a part of the company means that contractors earn dividends when the company makes profits.
Possible sound investment
- For a contractor with a long-term investment strategy and a keen eye for investing, stocks are always a great idea. What’s more is company stock options mean that contractors can invest without paying broker fees.
No value restrictions
- Employers can offer however much they like.
Transferable to others
- Unlike ISOs, NQSOs can be transferred to others, such as family members and charities.
Expiration up to the agreement between contractor and employer
- ISOs have a maximum expiration date of 10 years from the grant date, but NQSOs don’t have that limit.
- The time it takes to meet the requirements of the company to become vested can give contractors pause. Contractors won’t actually own the NSOs until they are vested. Vesting schedules can be cliff-type (where all of the NQSOs will be vested at once after a certain time) or graded (where the NQSOs are vested gradually, e.g. 25% per year, so they will be fully vested after four years).
- NQSOs are not taxed upon granting or vesting, but upon exercising and selling. The difference between the market value of the stock and the exercise price will be taxed as ordinary income.
- There isn’t a secondary market for NQSOs, unlike regular public traded stock options. If the market price is lower than the exercise price of the NQSO, then it becomes basically worthless.
The benefits and risks of stock options for employers
- Employers can maximize the retention of their money for business tasks rather than compensating contractors fully with money.
Increase staff retention
- Contractors have a personal stake in the company’s success and want to do what they can to contribute to it.
- Dilution can be very costly in the long run
- Stock options can be difficult to value
Taxes and technicalities
More information regarding NQSOs and taxes, in addition to all that’s already been said:
- Taxes are only owed when NQSOs are exercised, and there may be a big tax bill when this happens
- There are several options to pay the tax bill
- There may be additional tax owed later
- Shares will expire if unexercised
- There are many strategies to exercise NQSOs
- NQSOs could possibly lead to concentration risk
- Stock options could end up being less than they are worth
Yes, companies can absolutely offer stock options to their contractors, but contractors need to consider how the vesting, taxation, financial planning, and investment management related to the stock options fit into their personal financial plan.
- Xu, Jiyao (Jackson). “5 Things You Need to Know about Non-Qualified Stock Options (Nsos).” X And Y Advisors, Inc., X And Y Advisors, Inc., 30 July 2020, https://www.xandyadvisors.com/blog/5-things-you-need-to-know-about-non-qualified-stock-options-nsos.
- Bruce Brumberg, JD. “Comparing Options: Nonqualified Stock Options vs. Incentive Stock Options.” Forbes, Forbes Magazine, 29 June 2021, https://www.forbes.com/sites/brucebrumberg/2019/07/09/comparing-options-nonqualified-stock-options-vs-incentive-stock-options/.
- Investopedia. Non-Qualified Stock Option (NSO) Definition, 5 October 2021, https://www.investopedia.com/terms/n/nso.asp.
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- Hcamag.com. 2021. The pros and cons of offering employee stock options. [online] Available at: <https://www.hcamag.com/ca/archived/the-pros-and-cons-of-offering-employee-stock-options/127502> [Accessed 5 October 2021].
- Zajac, D., 2021. 10 Things You Need to Know About Non-Qualified Stock Options. [online] Zajac Group. Available at: <https://zajacgrp.com/insights/the-top-10-things-you-need-to-know-about-non-qualified-stock-options/> [Accessed 5 October 2021].
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