Incentive compensation is compensation based on the performance of a company. Companies of any size can use incentive compensation as a means of motivating and rewarding those who work for the company by aligning their interests with those of the company itself and its owners. There are several types of incentive compensation. The right type or types for your company will depend on what type of entity your company is, how much money it has, how successful it is, and what type of employees, contractors and suppliers it has or is looking to attract.
One type of incentive compensation corporations can use is stock options. Most people have heard of stock options – they are behind some of the huge start-up pay outs in the news and even find their way into TV shows and movies. But what are stock options really? Stock options are what the term suggests: the option to buy stock. To use a less circular definition, they are the right to purchase up to a certain number of shares of stock at a predetermined price per share during a specified period. The IRS differentiates between two types of stock options: one that confers income tax benefits when exercised (often called incentive stock options) and one that does not qualify for such beneficial tax treatment (often called non-qualified stock options).
Before a corporation can award either type of stock option – or any incentive compensation for that matter – it needs to adopt an incentive compensation plan. The plan sets the parameters for its administration and the various types of incentive compensation allowed under the plan. Since recipients are employees or at least work with the company in some capacity, a good plan will include an explanation of what happens when that relationship terminates. The outcome can vary based on what ended the relationship – death and disability might lead to a different outcome than termination for cause. This is how a corporation keeps someone who turned out to be a difficult employee and was quickly fired from becoming a difficult shareholder who sticks around for a lifetime.
The plan itself is not the document by which stock options are conveyed to recipients, the plan is just the rule book. Stock options are conveyed by an agreement between the company and the recipient, usually called award agreement or a grant agreement. This agreement specifies who receives the stock options, the date received, the number of shares the recipient will have the option to buy and the price at which they can be bought (often called the exercise price). It may also include a vesting schedule which specifies the when in the future the recipient will have a right to the stock options. Vesting schedule can be based on the passage of time or meeting milestones, like sales or revenue.
When dealing with stock options it’s important to remember what stock options aren’t: stock options are not stock. Receiving stock options does not make the recipient a shareholder; exercising stock options does. The corporate carrot here that makes stock options a key component of a corporation’s incentive compensation plan is the potential for the recipient to make a profit by exercising when the actual stock price is higher than the exercise price.
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