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- Equity 101 Part 1: Startup employee stock options
- How Do Stock Options Work? A Guide for Employees - Smartasset
- What You Need to Know About Stock Options
Your manager may well agree that is is fair for someone who has added a lot of value to the company to own stock even if they leave earlier than expected, especially for something like a family emergency. These kinds of vesting accelerations are entirely discretionary, however, unless you negotiated for special acceleration in an employment agreement. Such special acceleration rights are typically reserved for executives who negotiate their employment offers heavily. Acceleration when a company is sold called change of control terms is common for founders and not so common for employees. Companies may impose additional restrictions on stock that is vested.
And it can happen that companies reserve the right to repurchase vested shares in certain events. Options are only exercisable for a fixed period of time, until they expire, typically seven to ten years as long as the person is working for the company. But this window is not always open. Options can expire after you quit working for the company.
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Often, the expiration is 90 days after termination of service, making the options effectively worthless if you cannot exercise before that point. In fact, you can find out when you are granted the options, or better yet, before you sign an offer letter. Recently since around a few companies are finding ways to keep the exercise window open for years after leaving a company, promoting this practice as fairer to employees. Whether to have extended exercise windows has been debated at significant length.
Key considerations include:. Everyone agrees that employees holding stock options with an expiring window often have to make a painful choice if they wish to leave: Pay for a substantial tax bill perhaps five to seven figures on top of the cost to exercise possibly looking for secondary liquidity or a loan or walk away from the options. On the other side, a few companies and investors stand by the existing system, arguing that it is better to incentivize people not to leave a company, or that long windows effectively transfer wealth from employees who commit long-term to those who leave.
It is possible for companies to extend the exercise window by changing the nature of the options converting them from ISOs to NSOs and many companies now choose to do just that. Another path is to split the difference and give extended windows only to longer-term employees.
With the risks of short exercise windows for employees becoming more widely known, longer exercise windows are gradually becoming more prevalent. As an employee or a founder, it is fairer and wiser to understand and negotiate these things up front, and avoid unfortunate surprises. The FAST templates give some typical guidelines about this. Confusingly, lawyers and the IRS use several names for these two kinds of stock options, including statutory stock options and non-statutory stock options or NSOs , respectively. ISOs are common for employees because they have the possibility of being more favorable from a tax point of view than NSOs.
But ISOs have a number of limitations and conditions and can also create difficult tax consequences. The option holder becomes a stockholder sooner, after which the vesting applies to actual stock rather than options. This will have tax implications. While stock options are the most common form of equity compensation in smaller private companies , RSUs have become the most common type of equity award for public and large private companies. Facebook pioneered the use of RSUs as a private company to allow it to avoid having to register as a public company earlier.
Each unit represents one share of stock or the cash value of one share of stock that the employee will receive in the future. RSUs are difficult in a startup or early stage company because when the RSUs vest, the value of the shares might be significant, and taxes will be owed on the receipt of the shares.
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But for cash-strapped private startups, neither of these are possibilities. This is the reason most startups use stock options rather than RSUs or stock awards. RSUs are often considered less preferable to grantees since they remove control over when you owe tax. Options, if granted with an exercise price equal to the fair market value of the stock, are not taxed until exercise , an event under the control of the optionee.
If the shares are worth a lot on the date of vesting , the tax burden can be significant. Usually you need the cash to buy shares—maybe more than you can afford to pay at exercise time. Another, less common approach to be aware of is for companies to allow the person exercising options to avoid paying the cash up front and instead accept a promise of payment in the future. The note may either be a recourse promissory note or non-recourse promissory note. If the note is non-recourse, for state law purposes the company will consider you an owner of the shares received in exchange for the non-recourse note, but the IRS will consider the shares still an option until the promissory note is paid which would also affect timing for long-term capital gains.
Of course, use of promissory notes is complex and entirely at the discretion of the company. Individuals considering the idea should discuss with a lawyer as well as the company. While most employee equity compensation takes the form of stock, stock options , or RSUs , a complete tour of equity compensation must mention a few less common forms.
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Phantom equity can have significant value, but may be perceived as less valuable by workers because of the contractual nature of the promises. Phantom equity plans can be set up as purely discretionary bonus plans, which is less attractive than owning a piece of something.
Two examples of phantom equity are phantom stock and stock appreciation rights :. For example, in a convertible note offering, investors may also get a warrant, or a law firm may ask for one in exchange for what is in essence vendor financing. An exception to the "stock options only" principle sometimes occurs during negotiations to attract and hire an experienced senior executive who may request restricted stock, but even then the benefits of an "everyone having the same" form of equity may prevail.
Equity 101 Part 1: Startup employee stock options
In this article, we provide an overview of some of the key considerations in making stock option grants: who gets an option, the size of the option, vesting terms and pricing. After the formation of a startup and prior to any significant financing, companies should and often do consider establishing a pool for providing equity grants to initial employees, consultants, advisors and directors.
For example, if the founders hold 9 million shares, a pool of 1 million shares might be set aside for equity grants, including stock options, to be made between formation and the anticipated time of a first financing. In this case, the pool would be 10 percent of the shares expected to be issued or granted under options and other equity awards prior to the financing.
There is no magic to 10 percent; the number should be based upon what the founders think they need in their particular situation. However, as a practical matter, some amount between 5 percent and 20 percent would be typical. See our article with more considerations about sizing an option pool. A new pool is often created as part of the negotiation for the first substantial financing, typically to provide for enough shares to cover the estimated number of option grants between the first and the second financing.
A typical pool following a Series A financing would be of around 15 percent of the number of post-financing shares outstanding or reserved. Of course, the shares of stock for the pool and for stock option grants should be for common stock, as there are tax rules that make it very difficult to grant stock options for preferred shares or stock that has distribution preferences.
How Do Stock Options Work? A Guide for Employees - Smartasset
Prior to the first financing, it is common to have consultants, advisors, board members and non-officer employees receive option grants of. Sometimes, the founding team identifies an executive-level hire for a permanent, full-time position. In those cases, a much larger grant could be considered; perhaps 2 to 5 percent for a seasoned VP of Sales or CTO if one is needed in the early days , to as much as 10 percent for a seasoned industry-experienced CEO.
For grants to employees, startups often move towards a relatively rigorous process in which employees in specific job titles receive a fixed not a negotiated amount of stock. Such a hiring matrix helps the management team use the allocated stock pool more effectively and creates consistency among employees always a virtue.
What You Need to Know About Stock Options
Further, after the company is funded, investors will expect the company to have such a matrix, and the board will expect management to keep all grants within the amounts specified in the matrix and, if amounts fall outside the matrix, the board will expect management to justify the exception. Such a matrix is usually based on industry surveys conducted by companies such as Radford, Advanced HR, J. Thelander Consulting and the Ravix Group. It is also not uncommon for angel or venture capital investors to provide guidance and help create company guidelines, which may be strongly influenced by local market practices.