Employee Stock Option Plans

When an employee receives company’s options for the first time, they have many questions, and the options agreement may look a little intimidating, because it includes so many new and unclear terms such as exercise price, vesting schedule, tax!!!! 

In this article, I will try to make it clearer. Here is my guide for the Perplexed. 

What is it?

Employee option is a right that the company grant to its employees, which enable them to acquire shares/stocks of the Company in the future at a predetermined price. The option is subject to certain terms defined in the contract, and it can expire.

The main mechanism

The company believes that, over time, the value of the company will go up, and the price per share will go up accordingly.  While the share price will go up the price that the employee will pay for his options (exercise price) will remain the same. The profit for the employee will be the difference between the future value and the current value of his shares.

The benefits

For the employer – high-value bonus with no need to withdraw cash. In addition, the options provide an incentive for the employee to continue working in the company and strengthen the relationship between the employee and the company.

For the employee – it is an opportunity to be a shareholder in the company and to receive appropriate compensation, if and when the company is sold or go public.

Basic terms

• Option – The right to buy the company’s share/stock
• Optionee – The recipient of stock options (company employee) 
• Grant Date – The date the options were granted to the employee
• Exercise Price – The cost to purchase a share/stock 
• Exercise Date – The date on which the Optionee exercised his option and purchased share/stock
• Exercise Notice – Written notice of the Optionee in which he elect to exercise his option into shares/stocks
• Vesting – The requirement that must be met in order to have the right to exercise the option, usually continuation of service for a specific period of time
• Exit – the moment that the employee can sell his options and meet the money, commonly in a merger/acquisition or an IPO (Initial Public Offering – When the shares/stocks of a company are sold to institutional investors for the 1st time. After the IPO, shares/stocks are traded in the open market).
• Section 102 – Section 102 of the Israeli Income Tax Ordinance – establish a set of rules on the allocation and taxation of employee’s options. I will explain more in the next paragraph.

Taxation in a brief

The main 2 question for option taxations are: 

1. What will be my tax rate? 
2. When should I pay that tax?

Section 102 of the Israeli Income Tax Ordinance defines whether the options’ profit will be considered income or capital gain and defines the tax payment date. The section distinguishes between assignment through the trustee and non-trustee assignment, allowing the company to choose between allocation routes.

• Options 102 in Capital Gains route – requires the employee to deposit the options with a trustee for a period not less than 24 months (blocking period). On the exercise date, the gain earned by the employee will be taxed as a capital gain at a rate of 25% provided that the additional conditions specified in section 102 are fulfilled. The employer is not allowed to deduct any expenses.
• Options 102 in income route – requires the employee to deposit the options with a trustee for a period not less than 12 months. On the exercise date, the gained earned will be added to the employee income and the employee will be taxed accordingly. The employer will be able to deduct expenses in the amount of the benefit that is added to the employee.
• Options 102 without trustee – Income will be classified as work income. In non-traded companies, the tax liability will be deferred at the time of the sale of the shares.

Basic common practice

• Option agreement is personal for each employee
• Grant mechanism is based on the time and rank of the employee
• Option vesting period is 4 years
• Cliff – 1 year (25%), and after that quarterly vesting (6.25%)
• The option expires after 10 years
• Each grant is subject to board approval
• The exercise price is equal or higher than the value of the company at the grant date

Have questions? Please feel free to contact us for any advice…

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