I introduce you to the private company in Lesson 11, "Options and the IPO," in connection with initial public offerings (IPO). The reality is that most private companies don't make an IPO. They remain private with no intention or goal of changing ownership forms.

Another reality is that there are many more private companies than publicly traded companies. Virtually every small business and many large ones are private companies.

Private companies, also called closed corporations, or closely held corporations, usually have just a handful of owners. These companies are often family owned.

There are a number of legal forms (sole proprietary, partnership, corporation, and so on) that people can use to accomplish their goals.

For example, a group of doctors may form a corporation to own and operate a clinic. Each of the doctors is a shareholder and has the rights and responsibilities of ownership.

Many private companies have restrictions that require shareholders to sell their stock back to the corporation or other existing shareholders if they want to leave. The sale may be based on some previously agreed to formula or the company may bring in an outside expert to establish a value for the stock.

In our example, if one of the doctors wanted to leave, the corporation or other shareholders would buy her out under a prearranged formula. The doctors might give a new doctor the chance to buy into the corporation by purchasing the departed doctor's shares.

Closely held companies face some significant challenges in providing equity compensation for their employees. Among these are

Private companies that plan an IPO in the future can grant options with the knowledge that when they issue stock, the market will place a value on the stock.

Despite all of these complications, private companies with no intention of doing an IPO still can and do offer stock options. They have the same options available to grant as publicly traded companies: nonqualified and qualified. The tricky part is placing a value on the stock at the time of the grant and exercise.

The primary difference between valuing a private company's stock and a publicly traded stock is the timeliness of the valuation. Publicly traded stock is valued every time there is a transaction. Employees can check the worth of their options or stock quite easily by using one of the many online services such as http://www.morningstar.com, or by looking at the stock's price in the financial section of the newspaper.

The private company may not provide the same information on a timely basis, since it often bases stock valuation formulas on financial accounting measures, which may take some time to calculate.

Employees of private companies may not receive updates on the value of their options and stocks more than once a month. This may take some of the incentive out of options.

Stock options granted by private companies must follow the same guidelines as publicly traded companies. Incentive stock options have the same holding period and accumulation requirements.

Where there may be some differences is in the underlying stock. As noted previously, some private companies place restrictions on their stock. These restrictions are more common in private companies than in publicly traded firms.

For example, the company may say that you can't sell stock acquired through exercising an option for three years. If you want to sell the stock during this period, you must sell it back to the corporation for what you paid for it.

Or the tax code may say that you do not really "own" the stock, since you are not free to do with it as you want and delay any tax due until the company lifts the restrictions.

The tax rules on restricted stock are complicated. I will touch on them in Lesson 13, "Employee Stock Purchase Plans," but you should consult a tax expert for specific advice in your situation.

Private companies may employ the same vesting restrictions as publicly traded companies. Under certain conditions, you may find the stock acquired through an employee stock option is unvested. When this happens, the IRS may conclude you really don't own the stock until it is fully vested and free from restrictions. These restrictions affect incentive stock options because they delay taxes until there is a sale of the stock.

Employee stock purchase plans, also known as section 423 plans for the applicable tax code, are another way to reward employees and compensate them with stock.

These plans are often favored over stock options by closely held companies for their ease of administration and the benefits they provide to employees. I cover these plans in more detail in Lesson 13.

Another alternative that accomplishes some of the same goals, but in a different environment, is the employee stock ownership plan or ESOP. ESOPs are very different in structure from the other plans in this book. I discuss ESOPs in Lesson 14, "Employee Stock Ownership Plans."

Stock appreciation rights (SARs) are another popular alternative for closely held companies. Publicly traded companies use SARs also, but private companies use them more often. The main reason private companies use SARs is that they have fewer alternatives. Public companies generally prefer options because they are easier to administer and are more familiar to employees than SARs.

A close cousin to SARs is phantom stock, which is another way of rewarding employees by allowing participation in the economic future of the company.

Both SARs and phantom stock are programs designed to accomplish many of the same goals as stock options and stock grants, while avoiding some of the negatives discussed earlier.