Granting employee stock options can best be thought of as slicing up your company’s equity and sharing them with employees to incentivize growth and foster team-focused culture.
There are many terms used interchangeably and depending on where you are in the world — equity compensations, employee stock options or ESOP, ESOW, EMI schemes. While there are differences in the way they're called, issued, or taxed, the concept and the intention is one and the same.
The basics
What are employee stock options
Employee stock options is a way to give equity (or ownership) in your company to employees. A slice of the cake, if you will. 🍰
There are several ways employees can gain a slice of their company. For example, employees can buy stock directly, obtain stock through a profit sharing plan or via worker cooperatives. But stock options are by far the most common, simple, and effective way to slice up the equity cake.
Issuing stock options to employees gives them the right (but not the obligation) to purchase company stock for a specific period of time at a predetermined price, known as "strike price".
Benefits of an employee stock option plan
Attracting talent. It’s no secret that cash can be tight for startups, which makes it hard to pay top dollar for talent. Using an ESOP, start-ups can offer tasty equity incentives to top-up slightly lower remuneration packages. The same applies for attracting experienced advisors and developers at an early stage. Knock their socks off with your idea, pay them in Options.
Retaining talent. It’s hard to attract top talent and even harder to keep it. Options are usually subject to Vesting, which encourages sticking with a company until the OptionsVest. That’s why it’s often called “sweat equity” – team members need to put in the blood, sweat and tears in order to eat their cake.
Opportunity for significant employee financial gain. By taking a slice of the ESOP cake, an employee can benefit from the increase in value of the stocks over the company lifetime. It offers hungry employees the chance to generate real wealth.
Salary top-ups. Tough times can often mean a company has to reduce staff salaries. To keep employee morale up (and the staff around), you can use an ESOP to ‘top-up’ paycuts with proportionate equity.
Incentivization. Potential ownership of a slice of the company means employees start thinking like business owners. It’s common to see a spike in collaboration, productivity, and innovation when ESOPs are incentivizing the team. One cake, shared goals.
Tax benefits. In many countries, start-ups and their employees are eligible to receive substantial tax concessions when implementing ESOPs. For more information about the tax benefits in your specific country, please get in touch with our expert legal partners and enjoy special Cake fixed-fees.
Glossary
Stock option terminologies
Before we dive in, here are some terminologies to help you better understand this guide.
- ESO or ESOP means Employee Stock Options or Employee Stock Option Plan.
- Exercise means the process of converting a vested option into an ordinary stock. An option can be exercised when the option has vested,and the exercise price is paid.
- Exercise period means the period in which an employee can exercise options. Often, an employee won’t exercise options straight after vesting, and will wait to exercise them later on(for example, at an exit).
- Exercise price means the amount to be paid by the employee to exercise the option. In many countries, an approved valuation is required to determine this price. This is often also referred to as a strike price.
- Exit event means when the owners of a company “exit” the business by selling the business, for example by initial public offering (listing) or acquisition by a third party.grant date means the date the options are granted (or “issued”) to the employee or contractor under the offer.
- Lapse means what happens to an option when specific vesting criteria is not met, and the option can be transferred back into the option pool for re-allocation.
- Offer means an offer for options made to an employee or contractor, made via an esop offer letter.
- Offer letter means the agreement setting out the number of options being allocated, the vesting conditions, and relevant exercise and options price. In some jurisdictions this is referred to as an award agreement or an option agreement.
- Option means an option to purchase a stock.Until an option has vested and been purchased. It is not a stock. It is a legal right to purchase a stock at a later date, if certain conditions are met.
- Option-holder means any employee or contractor who has been offered (and accepted such offer) options to purchase stocks under an esop.option price means the price the employee pays to be granted the options. In most jurisdictions, this is usually set at $0.
- Start date means the date the vesting period starts ticking. This can be the start date of employment, or another date.
- Strike price has the same meaning as exercise price.
- Vesting means the process by which the option-holder earns full rights to their options, to allow them to be converted to stocks. This can happen by way of meeting certain time-based vesting conditions, or other performance-based milestones. Only vested options can be exercised to become stocks.
- Vesting period means the time from the start date, to the date the last options will vest under the vesting conditions.
The NITTY GRITTY
How do employee stock options work
The company creates an ‘Option pool,’ setting aside Options that can be allocated to employees or contractors. Consider this one slice of cake, from which smaller nibbles are then allocated.
The standard option pool size is 10% but it can vary between 5% to 30%.
The option pool doesn’t need to be allocated immediately. In fact, it’s often better to leave unallocated options to use for later hires or to top-up remuneration packages.
To simplify how stock options work, there are 3 main things that needs to happen before stock option holders can eat their cake: Granting, Vesting, and Exercising. The employer grants stock options. If the employee complies with the rules, the options vest. Then they can exercise their options to purchase stocks.
In this article we will deep dive on each part of this process.
An Option pool can be created on your Cake account in minutes. Learn more.
The Plan Rules
Granting stock options
An employee receives an agreement outlining the rules of his grant. Just like any legal document, signing this agreement binds an employee and employer to a set of terms. In Cake's platform, a stock options holder typically receives an Offer Letter to start, and then a more detailed Plan Rules to be signed by both parties.
Why do we need Plan Rules
The Plan Rules set out the rules and processes for option-holders and stockholders. The Plan Rules and the Offer Letter should be read and understood together. You can think of the Plan Rules like a stockholders agreement that applies to employee stock option recipients.
Plan Rules provide full transparency, helps avoid disputes and gives the company peace of mind that it’s protected in various scenarios.
Generally, the Plan Rules cover important issues such as:
- The right of the company to buy stocks back from Option-holders
- The price at which the company can buy the stocks back from the Option-holders
- What happens if an Exit Event is likely to occur
- Whether the Option-holder can transfer his or her Options or stocks, and the restriction periods
on the transfers - The company’s right to take certain actions in the shoes of the Option-holder, where the Option-
holder is not cooperating
The terms of any Offer that are specific to each employee (such as the number of Options allocated,
The Vesting Rules, and the Start Date will be set out in each Offer Letter.
Cake has created Plan Rules using best-practice standards in the United States, or whatever country your employee is based. If you need to create Plan Rules, it’s important they comply with the laws and regulations of that specific country. Learn more.
Our expert start-up legal partners can assist with any amendments, advice on approvals required (like Board or Member approval) or the terms of your Offer Letters and Plan Rules.
The Vesting period
Vesting stock options
Under an employee stock options plan, the option-holder is not able to exercise options until those options have vested. And until the options are exercised, the option-holder does not have any stockholder rights (like voting rights, for example). So, until options have vested, the option-holder can't gain full rights to their slice of the cake.
Vesting is a little bit like dangling a carrot. The purpose of vesting conditions is to tie some obligation of performance (or time) to the Options. It’s why stock option plans are such a powerful tool for incentivizing your team to stay longer and work smarter towards the ultimate success of the company.
Time-based vesting
Time-Based Vesting can occur by way of a cliff, period vesting, or aPeriodic Vesting, or a combination of both.
Cliff vesting
Think of a Cliff as the probation period for equity. It’s a period of time before any options vest. It’s usually set at one year, which gives the company time to see how the option-holder performs, before they receive any equity.
For example, if Tracey has a 12 month Cliff, 25% of her options would vest 12 months after her start date.
Period vesting
These are options that vest gradually over a period of time (what we call as the "vesting period").
For example, if Tracey has a 4 year vesting period, after Tracey’s 12 month cliff, the remaining 75% of her options would vest quarterly, over 3 years. So, at the end of month 15, another 6.25% of her options would vest.
The vesting period will usually start from the employee’s start date. It can also be set retrospectively, so the employee is rewarded for any time spent in the business prior to the grant of options.
The start date can also be set to start at whatever other date the company likes. For example, a company can create a stock option plan where the start date for vesting is the same for all employees, regardless of when they started.
Milestone Vesting
Options will vest on the achievement of some defined milestone or performance hurdle. For example, the remaining 25% of Tracey’s options could vest on her ‘recording $200k in sales for the company during 2022’.
Generally, milestones are only appropriate when clear metrics can be defined. For example, a sales role where vesting is tied to results.
Most common vesting arrangements
The most common vesting conditions we see are: 25% of options vest after a 12 month cliff; the remaining 75% of options vest quarterly, over 36 months after the cliff date. You can have default vesting condition set up in your Cake account, or customise for each option-holder.
In Cake, vesting schedules are clearly set out in a visual format, for both the option-holder and the company to understand at a glance. Without this tool, things can get a little messy.
Keeping the team engaged
The Cake platform tracks vesting, and automatically provides updates as vesting events occur.
Cake also notifies the company and option-holders each time a vesting event occurs, so they are always reminded of the options they’re accumulating. A neat way to keep equity top of mind for teams.
Transparency on the Cake platform makes the options feel more tangible, and will avoid you needing to regularly provide updates to option-holders on their vesting status (admin can really take the fun out of sweet treats). Any startup founder can use some help in these areas, which is why the Cake app was conceived. See for yourself, sign up today.
What is an accelerated vesting?
The Plan Rules set out what happens to unvested options in the case of an exit event. Most Plan Rules contain an 'accelerated vesting’ provision, which provides that in an exit event, all unvested options will automatically vest. The logic here is to disincentivize employees delaying an exit event, to make sure their options have vested first.
What if options do not vest?
If the options do not vest (eg, because an employee does not stay for the entire vesting period), they lapse. This means they can no longer vest nor can be exercised by that option-holder. The lapsed options can be recycled back into the option pool and allocated to new employees, or top-up current employees. There is no need for a ‘buy-back’ for unvested options.
What if the employee leaves?
The Plan Rules may contain general ‘buy-back’ provisions, which give the company the right (but not the obligation) to buy stocks back from employees when they leave the company.
The Plan Rules may set out the price which the Company must pay to buy-back stocks when the employee leaves. The price will be based on the circumstances in which the employee leaves - i.e. whether they are a good leaver or a bad leaver.
The Plan Rules may also clarify what defines a good leaver or a bad leaver, and how the ‘Fair Market Value’ is determined.
What happens if the company is sold or listed?
The Plan Rules will specify what happens to the options if an exit event, like a takeover, occurs. Generally, the way the options are handled will be left to the board’s discretion.
Usually, the option-holder will be provided an opportunity to exercise their options, to become part of the sale or listing as a stockholder.
Alternatively, if the exit event is an acquisition, the acquirer will often choose to cancel the options instead and pay each option-holder the same amount as if they were stockholders. This avoids the option-holders needing to exercise their options, just to be bought out immediately after.
Will the options and stocks be diluted?
Just because an option-holder might be offered options equal to ‘3% ownership’ of the Company at the time the ESO offer is made, it does not mean they will always own 3%. Unless the ESO plan includes anti-dilution rights (which is very rare), the percentage ownership will be ‘diluted’ each time more stocks or options in the company are issued.
For example, if after making the offer, the company does a capital raise and offers new stocks for 20% ownership in the Company to an investor, the potential 3% ownership, has now become 2.4%, and so on.
But this isn’t necessarily a bad thing. Investment generally means the company is on an upward trajectory. Would you rather own 1% of a $100m company or 5% of a $1m company?
When it comes to managing your employee stock option plan, Cake does the heavy admin lifting for you. Get started with your free trial today!
The Plan Rules and the United States’s laws may affect the treatment of a sale or listing of a company. Cake’s global legal partners can assist you in understanding the relevant provisions in the United States.
A piece of cake
Equity can be faster, simpler, and easier -- dare we say it, a piece of cake!
Our end-to-end platform allows you to plan, create, approve and manage your employee stock options minus the complexity. On average, our solution takes 85% less time and costs 90% less money than the average DIY equivalent, and you can get set up in minutes.
Cake works closely with expert start-up lawyers and accountants around the world. If you want some extra advice, we can put you in touch with one of our partners. Get started.
The Exercise
Exercising stock options
Exercising stock options means you’re taking action to purchase shares of the company that has issued you equity, typically through a stock option grant.
Does an option-holder have to pay to exercise their options?
Usually, an option-holder must pay the exercise price to exercise any options. The Offer Letter will set out the exercise price.
The need to pay an exercise price can confuse recipients. For example, if an option-holder received $25k worth of options as a top-up on their remuneration package, it would not make sense for them to have to pay $25k cash to exercise those options once they’ve vested.
However, it is rare that an option-holder would ever need to do this. Either:
- the exercise price would be calculated by a valuation method which yields a nominal price per option (i.e., $0.01 per option), or
- the Option-holder can hold off exercising the options until there is immediate value in doing so (i.e. at an exit event).
If the exercise price is high and the option- holder wants to hold off on exercising the options, they could keep the options as ‘vested options,’ and not exercise them until:
- an exit event is occurring, and they can be part of the sale or listing as a stockholder, or
- they will leave the company and the company elects to buy the options back at the increased value. Owning a smaller part of a bigger Cake can be very sweet indeed
Can an option-holder sell the options or stocks?
The Plan Rules will set out all the rules relating to selling Options and stocks. The Plan Rules will often provide an exception to the rule for a disposal to an affiliate, for example, a direct family member, or a family trust.
The Regulatory stuff
How are stock options taxed
In the US, stock options are either Incentive Stock Options (ISO) or Non-qualified Stock Options (NSO).
Under an ISO:
- Only employees can be granted options. Contractors or advisors cannot be granted options.
- There is no ordinary income tax upon exercise of options.
- There is no employment tax upon exercise of options.
- When options are exercised for profit, those profits are taxed at the capital gains tax rate (typically 15%), which is lower than the rate at which ordinary income is taxed, making it hugely beneficial for the employee from a tax perspective.
Profits from NSOs are deemed ordinary income and aren’t eligible for the same tax breaks. Whilst NSOs might have higher taxes, they can also afford companies more flexibility in terms of who can be granted options and how they can be exercised.
In the USA, the regulatory requirements will vary from state to state. As always, our expert legal and accounting partners are ready to help you work out which rules apply to your stock option plan.
