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 access to significant amounts of money as bigger companies do.
However, there are a few things to contemplate when considering offering stock options to contractors.
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 also 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). Once a person exercises their stock options, they will subsequently own company shares.
Companies can offer stock options to contractors for many reasons. They might do so as an extra incentive alongside a salary, or as a form of compensation because the company doesn’t have that much money (yet), to garner loyalty from the contractor, as owning stocks would mean they have personal interest in the success of the company, or simply as a reward.
Stock option grants will usually 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 or exercise stock options and means that companies can impose certain requirements before the contractor can vest their stock options.
If the contractor leaves the company before their stock options are vested, then ownership of the stock options belongs to the company. As such, vesting is an excellent retention tool for companies.
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 Alternative Minimum Tax (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
- Grant date: This is the date on which the company makes the stock options available to the contractor.
- Vesting date: 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.
- Exercise price: 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.
- Expiration: The date on which the NQSOs will expire.
The benefits and risks of stock options for contractors
The main benefit of stock options for contractors is that 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.
There are also the financial rewards from a successful business, because owning a part of the company means that contractors earn dividends when the company makes profits.
These two benefits combined mean that contractors are invested in the company and want to see it succeed.
For a contractor with a long-term investment strategy and a keen eye for investing, stocks are always a great idea. They are likely to be a sound investment. Additionally, company stock options mean that contractors can invest without paying broker fees.
There aren’t any value restrictions on stock options, so employers can offer however much they like. If contractors feel that they don’t want to have all of those stock options, NQSOs can be transferred to others, such as family members and charities (unlike ISOs).
If the contractors aren’t quite sure what to do with their stock options right away, this should not be an issue either. This is because the expiration of the stock options is up to the agreement between the contractor and employer. ISOs have a maximum expiration date of 10 years from the grant date, but NQSOs don’t have that limit.
Sometimes, the time that it takes to meet the requirements of the company for stock options to become vested can be an issue for contractors. Contractors will not actually own the NSOs until they are vested. Vesting schedules can be time-based (where all of the NQSOs will be vested at once after a certain time otherwise known as a cliff) and / or milestone-based (where the NQSOs are vested gradually, e.g. 25% per year, so they will be fully vested after four years).
There is also the matter of taxation. 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.
And finally, there is no 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 will become worthless.
The benefits and risks of stock options for employers
Stock options are cost-effective for employers as it means that they can maximize the retention of money for business tasks rather than compensating contractors with money.
Additionally, because contractors have a personal stake in the company’s success and want to do what they can to contribute to it, stock options increase staff retention and loyalty.
The main risk for employers is dilution. Dilution lowers the amount of power that the employer has in the company, and can be very costly to shareholders in the long run.
Beyond this, the only other real issue is that stock options can be difficult to value and therefore can result in high levels of compensation for mediocre business results.
Taxes and technicalities
Here’s a little 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.
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