How stock options work in startups? Stock options have become a popular mode of compensation for employees. Since startups often struggle with affording competitive salaries for their employees, stock options make for a great incentive for employees to stick around. Stock options are offered by startups to their employees, so they may agree to work for lower salaries.
When employees know they have a stock options incentive, they have an opportunity to earn more in the future as the startup becomes profitable. However, a lot of employees aren’t really sure how stock options work in startups. Similarly, often startups aren’t sure how they can use stock options as a way to compensate their employees.
The core concept of stock options is pretty straightforward. When an employee receives stock options, they become eligible to buy a certain number of shares in the business they are working for. With that said, there are different types of stock options and each of them have different benefits for employees. So if you want to know all about stock options and how they work for startups, then we suggest you keep reading.
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What Are Stock Options?
We have already established that Stock Options are used to offer employees a fixed number of shares in a business. To better understand stock options, think of them as a contract between the startup (employer) and the employee.
When an employee receives stock options as part of their financial package at a startup they are getting an option to buy stock at a certain price. So even if an employee gets 100 stock options, they don’t own 100 shares in the company straight away. They instead have the option to purchase 100 options at a predetermined price.
The predetermined price of the shares is called the grant price, and the grant price, as well as the number of stock options, vary depending upon the seniority and role of the employee.
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Different Types Of Stock Options Offered By Startups
Now that we know what a stock option is, it is important to know the different types of stock options that can be offered to employees.
Generally, there are two key types of stock options called incentive stock options and non-qualified stock options that are offered by startups. Here is how both of these types of stock options compare:
Incentive stock options (ISO)
Incentive stock options are also referred to as ISO, and they are eligible for special tax treatment. Incentive stock options must qualify to certain criteria to qualify for the special tax treatment:
- ISO can only be offered to employees by startups and not to contractors and other partners
- Incentive stock options have a grant value of $100k
- If an employee wants the tax benefits that come with ISO, they must exercise their option within three months after their employment is terminated
Non-qualified stock options (NSO)
Non-qualified stock options, also called NSOs, are different from ISOs in more than one way. For starters, NSOs don’t qualify for special tax treatment, unlike ISOs. Hence, the term non-qualified is used to refer to the NSO. NSOs are reported on your tax forms and when an employee wants to sell their NSO the money raised by selling the stock will be taxed under capital gains and losses rules. So, figure out how stock options work in startups when working out compensation.
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What Factors Need To Be Considered Before Offering Stock Options?
Stock options are a great way to acquire and retain talent for startups. However, it is essential to consider all the factors before offering stock options to employees. With that said, here are some factors startups need to consider and some terms you need to be familiar with before issuing stock options:
Total authorized shares: Total authorized shares refer to the maximum amount of shares a company can issue. As a startup, it is easy to overlook their capacity to issue stock and end up issuing too many shares in the form of stock options.
Generally, the total authorized shares are determined by the board of directors for larger firms. However, the employee options pool should be kept between 5-25% of the company’s stock. So your goal should be to limit the total authorized shares to prevent dilution when issuing stock options.
Number of options being offered: Startups have to determine how many options they should be granting to each employee. In most cases, the amount of options being offered to an employee is negotiated at the time of hiring. However, as mentioned earlier, the number of options an employee is offered depends upon their seniority level.
Since there is no specific formula to determine the number of stock options each employee should receive, job positions are a great criterion to determine the number of stocks being offered.
Valuation: The grant price is determined after a fair market valuation. It is best to get this valuation done by a third party valuation provider to get an unbiased grant price. That’s how stock options work in startups.
Termination of stock options: Even if an employee is offered stock options, it doesn’t mean that they will remain employed forever. Startups should make this clear at the time of offering stock options to prevent any misunderstandings down the road.
Exercise time: When employees have a stock option agreement with a startup, they can activate the agreement within a specific date. If an employee is terminated, the exercise time is reduced.
Startups must set the exercise time carefully when making a stock options plan. In general, the exercise time is between 1 and 3 months. An employee can exercise their right to purchase stock options at a grant price during this period after being terminated from a startup.
Vesting time: Vesting time should be decided before issuing stock options to employees to have a clear vesting schedule that employees have to follow. Vesting time is the minimum amount of time that the employees have to work in the company before they have their stock option rights vested to them.
The vesting time is usually divided into parts, where an employee gets a certain percentage of shares vested to them. The vesting period can be as short as 3 years or as long as 5 years. The employees may receive 25% of their stock option rights in the first year, until they are 100% vested over the next 3 years. That’s just one of the ways how stock options work in startups.
Vesting schedule for stock options: There are three types of vesting schedules for stock options that you can choose from:
Immediate vesting schedule: Immediate vesting period is the most attractive schedule for employees because it gives them immediate vesting rights to stock options.
Graded vesting schedule: Graded vesting schedule is a schedule where an employee gets gradual rights to stock options over a certain period of time.
Cliff vesting schedule: The cliff vesting schedule gives employees the right to receive full benefits of their stock option at a set date. Usually, a cliff vesting schedule starts giving employees the complete benefits after they complete one year in the company.
Exercising stock options: As we mentioned at the start of the article, when employees get stock options they don’t actually get shares in the company. Exercising stock options happens when the employee uses his/her right to buy shares in the company at the agreed upon price.
When an employee exercises their stock options, they own a share of the company.
How Do Stock Options Work?
Stock options have two major components. The first is the granting of the options and the second is the exercising of the options. The process of granting and exercising stock options is similar for startups and mature companies. In order to help you better understand how stock options work in startups, we are going to use a hypothetical startup as an example.
- A start-up named XYZ hires an employee named Luke at a relatively lower pay scale
- As compensation for the lower pay rate, XYZ offers Luke stock options where Luke can buy 10,000 shares at $1 each
- The company has put a four-year vesting period on the stock options and a one-year cliff vesting schedule. So Luke gradually vests the complete benefits of the stock over the next 4 years. However, if Luke is terminated before his one-year cliff vesting schedule is complete, he doesn’t get the rights to any stock options
- If Luke manages to complete the vesting period and all other criteria of the stock options agreement, he can buy all the 10,000 shares at $1 per share. This means that even if the share price of the company XYZ is high by the end of 4 years, Luke still gets the shares at $1 per share
- Luke has a chance to sell the 10,000 shares that he bought for a lower grant at a profit
- Let’s say the share value of the company XYZ is $10 when Luke decides to exercise his stock options. Since Luke bought the 10,000 shares at a total price of $10,000 he can sell them for $100,000 when the share price reaches $10 and make a significant amount of money
Of course, this example is an oversimplification and there can be a lot more steps from issuing stock options to the employee exercising them. However, for most startups, this example is a good representation of how stock options work. Since employees have an incentive in the form of a chance to get a big payout if the stock prices of the company go up, they may stick around until the end of the vesting period.
As for the startups, they don’t have to give shares of their company to their employees, but in return, they get to hold on to talented employees even if they can’t pay them high salaries at the start.
While on the subject of stock options, every entrepreneur should know what are preferred shares and how they should be allocated. If you would like more information, check out this video I have created.
What Are Some Benefits And Pitfalls Of Offering Stock Options As Compensation?
While stock options offer a convenient way to compensate employees without spending a lot on salaries, this compensation strategy comes with its own pitfalls. With that said, here are some pros and cons associated with offering stock options:
Ownership for employees: Stock options essentially offer ownership of the business to the employees. Which means they feel more invested in the business and have an incentive to help it grow.
Cost-effective: Startups with limited budgets can create attractive employment packages using stock options as compensation.
Improved employee retention: Employees are required to complete the vesting period of stock options by remaining a part of the company for a specific period. This can also improve employee retention as employees have an incentive to keep working in the startup to fulfill their vesting schedule.
Long term financial strategy for employees: Employees that are looking for a long term investment may find stock options an attractive investment opportunity. They can invest a small amount while exercising their stock options for a chance to get significant returns.
The taxation is complicated for employees: If employees don’t get the incentive stock options, the taxation is complicated for non-qualified stock options. For this reason, some employees may avoid taking stop options as compensation.
Dilution: When your startup goes public, having too many employees with a lot of stock options can cause dilution. Dilution can be bad for shareholders over the long run and can hurt the interests of individuals who buy a company’s stock.
Complicated valuation process: Since grant price is set after making a market valuation, it can be tricky to accurately evaluate a startup.
Poor performance: Cash incentives are still the most effective way to compensate high performing employees. If a startup is focusing on compensating their employees primarily through stock options, they may face poor performance related issues. When employees won’t feel like they are getting immediate cash compensation, there is always a risk that their performance may drop.
Stock options are gaining popularity among startups due to the advantages stated above. However, they do come with their own set of disadvantages. This article was aimed to help employees and startups better understand what stock options are and how they work, so they can make a more informed decision when issuing or receiving stock options.
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