Some people confuse the requirement to offer employees an option to buy stock in the company through the 401K Plan with offering stock options to employees. These are not the same thing. You may do both, although most people who create a ROBS have no interest in stock options. Here is how they each work.
An Option to Buy
When the corporation makes stock available through a 401K Plan, it must do so to all employees. This purchase cannot exclude any qualified employees. A plan may be written to exclude seasonal employees, union employees, and a few other uncommon employee categories. The purchase is allowed to be limited to a “reasonable” length of time. Any employee of the corporation during that time period has, what some people refer to as, an option to buy stock. I find confusion often clears up if we use the word right rather than option in discussing this concept. Employees have a right under federal labor law to decide for themselves whether they want to participate in the stock purchase having all relevant information available to them to make an informed decision. Once the time expires, this right ceases.
The stock price for shares issued to the Plan are issues at fair market value, not a discount. The price remains the same for the entire time frame of the offering. Employees must use only qualified money to make this purchase and their qualified funds must either be eligible for contribution or rollover to the Plan. This does not open up a right for them to purchase company stock with their self-directed IRA. This does not allow any employee to use personal or non-qualified funds to purchase stock. Depending on the wording of the Plan documents, the employee might not have a right to sell at any set time or price, making the stock fully non-liquid.
Plans also contain a vesting schedule, another term common to employee stock options and source of confusion. The plan’s vesting schedule relates to the length of employment time required to vest in company contributions to the plan on the employees behalf. Could those company contributions be stock options rather than cash? Under the rules, yes, but in practice, this will create such a valuation issue for you that I strongly advise against it. A ROBS purchase must be for stock, not options to buy stock, executed at fair market value.
Buying an Option
When a company sells or issues a stock option, the employee has a right to exercise that option under specified circumstances. An employee stock option is a contract issued by an employer to an employee to purchase a set amount of shares of company stock at a fixed price for a limited period of time. Employees are typically not granted full ownership of the options on the initiation or grant date of the contract. They must comply with a specific schedule known as the vesting schedule when exercising their options. The vesting schedule begins on the day the options are granted and lists the dates that an employee is able to exercise a specific number of shares. For example, an employer may grant 1,000 shares on the grant date, but a year from that date, 200 shares will vest. The year after, another 200 shares are vested, and so on. The vesting schedule is followed by an expiration date. On this date, the employer no longer reserves the right for its employee to purchase company stock under the terms of the agreement.
An employee stock option is granted at a specific price, known as the exercise price. It is the price per share that an employee must pay to exercise his or her options. The exercise price is important because it is used to determine the gain and the tax payable on the contract.
Simplifying the Issue
A ROBS arrangement creates a right for an employee to purchase stock in the corporation at fair market value using qualified funds within the plan for a specified period of time. For most of my clients, they themselves are the only employees ever eligible to purchase stock through the plan. The Plan is, of course, made available to all qualified employees, but this does not mean the right to purchase company stock is still available.
If a company wants to also offer stock options as an employee benefit, I recommend they find a securities attorney in their state. Very different set of rules, even if some of the terminology is the same.