Startups often rely on stock option grants to attract and retain key talent.
But while stock options sound simple enough on paper, they can be hard to manage in practice, particularly as your company grows and its ownership structure becomes more complex. They also expose founders and employees to different risks.
So how do stock options work and what are the pros and cons you should be aware of?
An option grant gives your employee the right to buy a set number of shares in your company from a specific date and at a pre-determined price.
The point at which your employee can exercise their option to buy shares is the vesting date. The price they’ll pay per share is the strike price, exercise price, or grant price. Here’s an example of how a stock option grant might work.
YourCo offers employee Jane options to acquire 10,000 shares at a strike price of 10 cents per share. These options expire after 10 years.
Under the vesting schedule, Jane has to be employed for 12 months before she will receive the rights to exercise the first 2,500 options. The remaining 7,500 options then vest uniformly over 36 months.
If Jane quits or is fired before the first year is up, she’ll receive no options. But if she’s still employed after 12 months, she‘ll have the opportunity to buy 2,500 shares at 10 cents each, even if the shares are worth more. Provided she remains employed for the subsequent three years, she’ll be entitled to the remaining 7,500 shares - again at 10c per share. Once the options are awarded, Jane can choose if and when she’ll exercise them as long as she does so before the expiration date.
Here are the main benefits from a startup perspective.
Option grants can entice the right people to join your organization without adding further pressure to company cash flow. Since staff must pay the strike price exercise their options, option grants actually result in capital inflow to your company.
Startups can’t compete for talent based on cash compensation, but they can make up for lost grounds by offering a sound long-term investment opportunity at a discounted price.
The chance to share the company’s future success could boost employee engagement and motivation, and foster a deeper connection to your business.
When your staff can tie business performance to personal gain, they may be more willing to go the extra mile to improve financial results.
Having a vesting period can lower staff turnover because they’ll have to stay long enough to earn their options.
Despite clear benefits, there are also key issues to consider with stock option grants.
What happens if the company performs below expectations or market conditions change? Due to these risks, employees may feel skeptical of stock options as partial replacement for cash compensation. A related consideration is the loss of morale if the company fails to achieve financial or growth targets.
Equity ownership amongst existing shareholders is diluted every time an employee exercises their options.
Stock option grants are not tied to individual but collective performance. An employee performing poorly may get the same financial rewards as a star performer.
As an unlisted company, you may need to facilitate the buying and selling of your shares by setting up an internal market.
Unless you have the right systems and tools in place, you‘ll need to put in a lot of time and effort to keep up with the administrative work involved.
You’ll need to draw up a stock option agreement for recipients of option grants. This will explain key terms including the type of stock option on offer, number of shares being issued, strike price, vesting schedule, expiration date, and more. You’ll have to figure out the following before drafting your agreement.
409A Valuation. You’ll need to know the fair market value of your company so you can set the exercise price for your options.
The size of your option pool. A pool is often created before the first funding round to incentivize initial employees. A second pool is then established later on to ensure there will be enough options for new employees hired between the first and second financing rounds. Typically, the size of a pool is between 5% and 20% of a company’s outstanding stock.
Who gets them and how much? Many companies adopt an approach where a fixed amount of options are offered to specific job titles or across an entire job grade. This makes the option pool far easier to manage and promotes consistency amongst employees.
Vesting period. How long will your employees have to wait before they receive their options? It’s important this period is long enough for them to get to know your company and understand how they might contribute to its success. It should also be long enough for you to identify any performance issues. As the earlier example shows, options don’t have to vest in one go. They can vest in tranches or gradually over a period of time.
Incentive Stock Options (ISOs) or Non-qualified Stock Options (NSOs). You’ll need to decide whether to issue ISOs or NSOs. As long as they meet statutory holding periods, there are substantial tax benefits to employees if you offer ISOs. However, from a company perspective, you can get a tax deduction for NSOs but potentially not ISOs — so you’ll need to weigh up the costs and benefits, along with the administrative burden involved with each to pick the right alternative.
There are several things you’ll need to track on an ongoing basis.
For starters, you should consider having your company independently valued every 12 months. This will allow you to set the right exercise price for your share options.
Every time a stock option grant is made, your capitalization table will need to be updated with the option holder’s details and the terms of the issue. When options are exercised, you’ll need to ensure your cap table reflects the latest ownership structure. It’s also important to monitor the option pool so you know how many options you’ve already issued.
It’s a lot of work, but the process can be streamlined — if you have the right tools.
Designed with the user in mind, Adnales makes it easy to capture the right information for your cap table. By offering opportunities to trade private company equity, Adnales can improve the liquidity and attractiveness of your company’s shares too. Its 409A valuations feature lowers the cost of getting independent valuations, and the extensive reporting functionality ensures you and your employees can access accurate information in a flash.
Option grants can be a win-win for founders and their employees as long as the emerging company is expected to grow. They align everyone’s interests and elevate your financial results to top priority for all.
But stock options affect your startup’s ownership structure, your personal stake, and have tax consequences for both the business and its people, so it’s important to get professional advice along the way.
Finally, investing in a reliable cap table management tool like Adnales means you can take advantage of the benefits of offering stock options without getting bogged down by all the admin. If you’d like to find out how Adnales can help your business, request a demo of our tool today! Opens a new window.