Startup stock is like a slice of cake: you want to be the first one to get a piece while it's fresh from the oven, and before everybody else gets their own share!
That's where startup stock options come in—they allow early startup employees of a company get their slice of the cake before everyone else does.
It goes without saying that equity sharing in later-stage companies have more complexities as more layers and tiers are added to the metaphorical cake. This guide explains the foundations of startup stock options, specifically in early stage startups where employee equity is every startup founder's (not so) secret ingredient!
Michael Houck, ex-Airbnb and ex-Ubereats, now CEO of Launch House, believes in the importance of startup employee equity. He says,
"Employee equity is super important. You want to make sure that employees, especially early employees who are making a huge commitment and taking a huge risk to bet on your startup versus one of the many of the other things they could do with their skills, are compensated for that and have the upside for that in the long run."
Whether you're a startup founder looking to create an employee stock option plan, or an employee looking to join a new startup and trying to understand the equity compensation you were just offered, allow us to help you in your journey!
In this article, we tackle:
- What are startup stock options
- Why do startups use stock options
- What are the types of startup stock options
- How do stock options work in startups
- When is the right time to set up a stock option plan
- Frequently asked questions on startup stock options
What are startup stock options
Startup stock options are a form of equity compensation that startup founders offer to their employees. In essence, they are an agreement between the employer and employee that gives the latter the right (but not obligation) to buy company shares in the future at a pre set purchase price.
What stock options are NOT, then, is a guarantee of financial gain. If the startup doesn't do well, or if it is sold before the options can be exercised, then the employee walks away with nothing. On the upside, if the startup does well, those employees who know how to exercise their options can gain significant financial returns from their investment into the company.
Remember this because it's important to understand both the gains and the risks before taking advantage of stock option plans.
Why do startups use stock options
Simply put, a stock option grant is a way for companies to effectively establish its pioneer team of employees by offering them equity in the business. The idea behind offering stock option grants is to attract top talent by providing them with an incentive—a potential financial gain if they stay with the company and contribute positively to the company's growth.
Stock options are essentially shares of company's stock given to employees at a discounted price (what we typically call "exercise price" or strike price"), usually below what they would pay on the open market. When an employee buys these stocks at a lower price, it gives them more upside potential if the company does well over time.
Attracting, motivating, and retaining employees
For your employees, considering stock options means they are getting a piece of the company they work for rather than just a pay check. This can be extremely attractive to people who want to invest in their future and the success of your business. Plus, it helps attract employees that may not have come to you otherwise.
"You want to make sure that everyone's bought into the future vision of the company. And as a founder, you want to make sure that people are going to be in it for the long haul and stick around, and are in it for something more than just a pay check."
Jason Atkins, co-founder of Cake Equity, believes that employee stock options enable you to attract and retain the best kind of employees who will grow with the company,
"The best people are attracted by having some skin in the game so you're gonna have a better quality team from the starting point. They're gonna be more engaged. And then there's also the retention element, especially in the first few years when you're finding product market fit and your brand's growing and your product's improving. So much of the IP is within those people's brains and the networks that they build. So you really want to keep them."
How would you pitch this to prospective employees, then? You could tell them that if they join your startup, not only will they get to be a part of something unique and exciting, but they also have the potential to gain equity in the company. If the stock does well, so do their holdings! This motivates them to invest in themselves and their future while being a part of your team.
Engaging and enlisting the help of advisors
Engaging with startup advisors is also beneficial particularly in the early stages where guidance from experienced experts are required. Startup advisors already understand the value of stock options and often prefer them over straight equity or cash compensations. They like it because they get to have a stake in the company in exchange for their knowledge and experience, without even working in the business full-time.
Advisory shares is also a form of stock option grant and typically fall in the same stock option pool. However, when you hear "startup stock options" particularly in the early stage startup scenario, it often refers to employee stock options.
Want to know more about advisory shares? We have a separate guide for that: Advisory shares: what startup founders need to know
What are the different types of stock options
The two most common employee stock options are incentive stock options (ISO) and non-qualified stock options (NSO).
ISOs are granted to employees of a company, and they are often used as a form of compensation. The benefit to the employee is that any profits from the stock options sale will not be subject to tax when exercised. This makes ISOs an attractive choice for startups because it allows them to offer their employees potential future gains without having to pay taxes upfront.
NSOs, on the other hand, are available for anyone who works at a company, not just employees; they do not qualify for favorable tax treatment like ISOs do. With NSOs, you may have to pay taxes immediately upon exercising your option, as the gains from NSOs are considered income. However, NSOs still offer the potential for significant profits in the future if the stock price goes up.
There are other types of equity grants: Restricted Stock Units (RSU), Stock Appreciation Rights (SAR), Employee Stock Purchase Plans (ESPP), or Phantom Stock, which are more common in more matured and later-stage startups. For the early stages, the most common ones are Employee Stock Options (NSO and ISO).
How do stock options work in early stage startups
Here's what typically happens when setting up employee stock option plans:
Deciding on the number of shares you like to offer
As a startup founder, you need to decide on the number of shares you'd like to offer to the employee. This can be done by calculating the dollar value at which each share will be sold and then dividing that number by the price per share of your company's stock. From there, you can determine how many shares you would like to offer.
Signing the startup stock option agreement
An employee receives a stock option agreement or stock option grant that outlines the rights of both employee and employer about their stock options, including any vesting conditions or expiration dates associated with them. An employee usually receives an Offer Letter to start, and then a more detailed document or Plan Rules that should be signed by both parties.
Stock option agreements are legal documents that typically contain the following information:
- Total number of shares granted
- Type of options
- Exercise price per share
- Grant date
- Vesting schedule
- Termination period
- Term of award/expiration date
- Administration and exercise of option
- ..and other legalese on non-transferability of options, tax obligations, change in control, governing laws, etc.
Waiting for your stock to vest
A stock option holder is not able to exercise options until those options have vested. And until the option is exercised, the option holder does not have stockholder rights. Which means until options have vested, the option holder don't gain full rights to their slice of the cake.
The purpose of vesting schedule is to tie some obligation of performance (or time) to the options. It’s why employee stock option plans are such a powerful tool for incentivising your team to stay longer (and work smarter) towards the ultimate success of the company.
Know more about vesting here: What is vesting and how does it work?
Finally, when it comes time for your employees to exercise their options, they will do so through a brokerage account that is connected to your company's records. The proceeds from this sale are then split between the employee and the company based on whatever rate was agreed upon in the stock option agreement.
It's important to have an exit strategy in place so that everyone knows what will happen if the startup sells or goes public before all of the stock options are fully vested. It's also important for both parties (you and your employees) to understand their respective rights when it comes to selling, transferring, or exercising their options.
When it comes to taxes, stock options can be taxed as either ordinary income or capital gains, depending on the type of option and how long it's held. Generally speaking, you'll want to make sure that both parties understand any tax implications associated with the stock option agreement before signing off on it.
Overall, understanding how startup stock options work can help ensure that everyone involved is fully informed when making decisions about equity in your company. All parties need to understand the risks and rewards before agreeing to any terms so that there are no surprises down the line!
When is the right time to set up an employee stock option plan
Are you ready to set up your stock options? Let us help you out.
We recommend setting up your Employee Stock Option Plan (ESOP) when you are in the early stages of growth. This is because having stock options at an early stage helps to attract and retain talent while also incentivizing employees to focus on long-term success.
Additionally, having an ESOP early on benefits both the founder (in attracting and retaining talent) and the employee (having a share of the company's stock while the exercise price is low) in a way that happens specifically in the early stages.
While ESOPs still exist in late-stage startups, early stage employees do enjoy a lower exercise price. As the fair market value of the stock rises, the high exercise price becomes increasingly expensive to purchase shares.
When setting up your ESOP, keep in mind that it requires significant planning and legal advice for all parties involved—employees, advisors, founders, investors. Startup founders should also set limits on how many shares you will offer to avoid diluting existing shareholders too much.
FAQs on startup stock options
How do I get startup stock options?
Generally, your employer will offer you stock options as part of your employment package. Read all the documentation provided by your employer carefully so that you understand the details about how many shares you can buy and at what price.
What are the advantages of stock options?
You can potentially make more money than if you had just taken regular wages. They also provide long-term incentives for employees, as they will not fully benefit from their investment until the company is successful. Lastly, they can be a form of compensation that doesn’t disrupt cash flow for startups with limited resources.
Are there any risks associated with stock options?
Your investments are tied to the success of the company, so if it fails or does not perform as expected, your stock options could become worthless. Additionally, depending on the type of startup you work for and its stage in development, there may be restrictions on when you can sell your shares.
How do I know which stock option is right for me?
It’s important to read all of the details provided by your employer and understand what type of investment fits best with your goals and risk tolerance.
What kind of return should I expect from stock options?
Returns on startup stocks vary depending on the type of equity-based compensation plan you choose, your employer's financial performance, and other factors. It’s important to carefully consider all possible risks before investing in any form of startup stock option.
Startup stock options made simple
Cake is on a mission to help startups through the process of setting up and managing an employee stock option plan. This way you can focus on effectively growing your business while giving back to those who helped build it.
Sign up for free and find out more about how we can help you get your ESOP up and running, like a piece of cake!
This blog is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.