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Understanding Employee Stock Options in a Startup

Are you a startup CEO thinking of offering employee stock options? Then continue reading to learn all the details of how stock options work.

July 31, 2021

Understanding Employee Stock Options in a Startup

Suppose you embark on the exciting and sometimes horrifying journey of building a startup; first, kudos to you! It's difficult, and we know you are, without a doubt, an all-star overachiever ready to rock it.

Do you find yourself wondering -- how do employee stock options work? As you put in everything you've got each day, how much thought have you given to employee stock options? Keep reading to get employee stock options explained in the simplest terms.

What are Employee Stock Options?

Stock options are not shares but rather an option to buy a share at a later stage. Employee stock options plan (commonly abbreviated as ESOP) gives a company employee the right to purchase shares from the startup company at a fixed price in the future, at an undetermined date.

ESOP is a way of giving the company's employees some potential hold of the company's equity.

The options are granted on top of the employee's salary, trying to align said employees and the company.

Should the startup company expand and become successful, then the employee stock options could be highly valuable.

Startup Stock Options Terminology 

As you understand how employee stock options work, a few terms get thrown around a lot. Here are some of those terms and what they mean.

Shares

A share represents a piece of a company that the shareowner owns. For example, let's assume a company has 1000 shares, and it issued 100 of them to Jane, 50 to Joe, and 850 were not issued yet.

In this case, Jane would when 2/3 of the company and Joe 1/3. The company owns the remaining 850 shares.  As Jane and Joe hold the company, the ownership remaining shares will be distributed between them.

Company shareholders have certain rights, which holders of stock options do not enjoy, such as the right to a dividend.

Stock Option

A stock option is a legal right to purchase a company stock/share(we will use stock and share interchangeably) at a given price called the strike price, regardless of the share price in the market.

A stock option is only valuable when the strike price is lower than the stock price in the market (referred to as being "in the money"). If the strike price is higher than the stock price in the market(referred o as being "out of the money"), one could simply buy the stock in the market.

A stock option details the terms such as:

  • The expiration date. After the expiration date, the option become invalidated.
  • The strike price - This is the fixed price the options owners can pay to exercise their option.

As options hold potential value in them (the potential difference between the strike price and the market price), they are valuable and can be purchased.

Employees Stock Option and ESOP

Employee Stock Option Plans are a special type of stock option. They are offered exclusively to the company employees, and they have some unique characteristics, especially an extremely long expiration period and a favorably low strike price.

Issue Date

The issue date is the date at which the stock option is assigned.

Strike Price

Just like in any stock option, the strike price is the price the employee will pay to change the choices to a share. A low strike price will represent an ESOP that is favorable to the employee.

Exercise price

This is basically the same as the Strike price as defined above. It is commonly used in a sentence, such as "Did you exercise your options?" asking if you paid the strike price on your options to exchange them for shares.

Vesting

Vesting is the rules and timeframe for when the employee has access to each batch of granted stock options offered. A designated period must elapse before someone can exercise all or part of the employee stock options.

Usually, employees will be granted a stock option grant which will be available according to the vesting plan.

Vesting Cliff

The vesting cliff refers to the time that has to pass before any options are made available to the employee. The cliff is usually one year, and it allows the startup manager to evaluate if they would want to cooperate with the employee for the long run and align them with the company. The assumption is that if the employee stayed with the company for less than a year, they shouldn't be entitled to be part of its future success.

How Do Employee Stock Options Work?

It is typical for startup companies to use employee stock options to get the attention of potential candidates. It also is a way to keep employees. Employee stock options are a way startups can compensate employees for their hard work by giving them a discounted promise of future success.

The vesting schedule is an incentive to stay with the company. An employee must meet the requirements as stated in the vesting schedule for the options for it to belong to them.

Let's say that you grant an employee 2,000 shares of stock options, and the vesting schedule is four years. This means that every year, you vest the employee in the stock options at 25%. So after the first year, the employee has 500 stock options.

To receive the full grant of employee stock options, the person must stay with the startup until the end of the vesting period. Thus, there's an incentive to stick out the rough patches that comes with startups and hang in there. Employees may get additional and overlapping ESOP plans to keep them incentivized to stay with the company in the long run.

Why Offer an Employee Stock Option Plan

We can allocate stock options instead of a higher salary. It is common for startup companies to be working on a budget and offer lower wages to their staff. 

The pay is often below the market rate, which is tough for recruiting new employees. The employee stock option plan should help startups compete for top talent. 

The employer wants employees who are all-stars ready to make contributions that will help their business explode. 

Payment to Exercise Employee Stock Options

Not all Stock Option Plans are the same, so you should carefully review each agreement. One thing that it will detail is the ways the employee can exercise the stock options.

Usually, you will find these terms in a section labeled "consideration."Consideration of the agreement, or payment, can be as deferred payment or cash. Whichever it is, you'll want to know what the methods are for exercising employee stock options.

One significant consideration is what happens if the employee leaves the startup before becoming fully vested or before the company is acquired. Things happen, and employees leave; new employees then come on board.

Typically, the vested shares must be exercised at some period after the person leaves the startup. So, the now ex-employee must hand over some money for the exercise price for the options, converting them to shares. This puts an employee who stays with the company at an advantage compared to an employee who leaves the company. The first can hold the option without exercising it, while the latter is forced to take the risk and invest the money in the strike price today, not knowing if it would have any value in the future. For that reason, financing tools for employee stock options were created, such as EquityBee. These services reduce the employee's risk while providing investors with access to a new asset class. The startup itself might not even have visibility that the exercise of the option was done using external financing.

Triggers and Success Events

Startups begin in hopes of a Success Event someday. Usually, this would mean a sale or the company has an Initial Public Offering. You'll want to review this part of the employee stock option agreement, particularly sped up vesting in such cases as a "Success Event." 

Single or Double Trigger

Often, it is one trigger, meaning a full or partial acceleration of the employee stock options unvested portion happens because of one Success Event. Less often, but occasionally, is a double trigger. 

A double trigger is for executive employees or co-founders. This is when two events must take place to speed up vesting. 

The first event usually is the sale of the company. The second event could be termination from the startup without cause. Both triggers would speed up a portion of the unvested stock options and usually protect executives and founders. 

Acquisitions or mergers can put an executive or founder in a position to be terminated so you can understand why this would be an essential term and condition for the employee stock option agreement.

Employee Stock Options Explained

When extending an employee stock option agreement, the startup's responsibility is to ensure that the employees are comfortable with the agreement and understand all the details.

This includes startup stock options tax. The same year an employee exercises their options, they must report the price break as taxable compensation.
You may wonder -- how many shares should I offer in an employee stock option package? It would be best if you based this on a few factors. 
The amount of stock option shares depends on the employee's role with the company and when the employee joins the company. The earlier the employee begins with the company, the larger the stock options should be. 
It is early on when the startup is treacherous and likely not worth much. Management has a tremendous amount of responsibility, so they get more shares as a part of their stock options.
Keep in mind that stock options are not the same as cash, and they don't hold value until exercised. Shares of stock are not even the same as cash. This is not the same as a wage increase or bonus.
It all depends on the company's success, as the startup's failure rate is high, and many don't make it through to maturity. Again, should that happen, the value of the shares of stock will be nothing, unfortunately. Employee stock options are not a replacement for salary or wages.

How Much Do You Give?

We recommend you set aside 20% of the company to award stock options. A good breakdown of 3% for key advisors and 17% for the staff. It would be best if you based the way you divide them up on the following four factors:

  • Role
  • Seniority
  • Risk layer (could be when the person joined the organization)
  • Choice (would you lean toward higher salary or bigger stock options grant?)

When you base how many stock options are on these four factors, it simplifies things because there is no need to negotiate on who gets what.

 

Should you go about setting up ESOP on your own?

As a startup founder, you should NOT even try to draft employee stock options to plan independently. You must consult with a lawyer who is specializing in startups and such ESOP plans. This issue can have implications on ownership and taxation, and you must not "wing it" but rather be very deliberate and plan about it. Our business is NOT legal to advise, but if you write us, we can try and connect you with someone who may help.

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