Stock Options for Startups: A Simple Guide
This post was originally published in technext.it See the post here: Stock Options for Startups: A Simple Guide
A startup’s essence lies in creating something exceptional with a group of devoted individuals who share similar goals and values, much like baking a cake alongside your fellow chefs.
But how do you keep all our co-workers motivated and aligned with your goal? By offering a piece of cake, right? And in the business world, that piece of cake is equity. But you can not split equity and offer shares to every one of your companies. In such cases, stock options are you lucky pass.
Say you are an early-stage startup founder who wants to attract talented employees by offering them stock options or an employee who got the stock option offered and needs to learn how it works or what to do next. This article will guide you both on how the stock option for startups works and how it will help you in the future.
Let’s Get to Know Stock Options for Startups
Let’s start with the basic ” what is a stock option” – Stock options are basically an agreement allowing employees to buy a certain number of startup’s shares at a predetermined price. As we all know, a startup needs committed employees to succeed, but it’s hard with limited resources.
This is where you, as a founder, can use stock options. You can offer stock options to your employees to encourage them to work in your startup. This way, your employees can also partake in the company’s success.
And you, as an employee, the premise is that if you believe in the company, you will work for its success. When the company succeeds and the stock price rise, you can purchase shares of stock at the predetermined price. A win-win situation for all.
I know what you are thinking – Yes, stock option grants do not provide direct company shares. It grants the employee the right to purchase shares in the future at an affordable rate. In other words, stock options are not stock.
A few things you need to know before jumping in
Understanding stock options can be if you are not familiar with some terms. So, let’s go over some of these terms to make it easier for you to understand. We’ll start with the most common ones.
Stock: A stock is a broad phrase that refers to any company’s individual ownership certificates. When you own stock in an organization, you instantly own a portion of the company that you can buy and sell easily.
Share: A share refers to a single unit of stock. After you purchase your share, you become a shareholder and possess a fraction of a percent of a company’s total stock or equity.
Stock option: A stock option is an assurance between a company and an employee that gives the employee the right to buy stocks at an agreed-upon price. You can buy or sell underlying stocks if you own a stock option.
Strike price: This is the price per share that your will pay when converting your options into shares. One of the main advantages of stock option plans is that the strike price specified in your options agreement is locked in and should not alter, even when the value of the company’s shares grows.
Issue date: In most cases, the issue date is when the company grants employees stock options. The issue date determines several components of stock options, such as vesting schedules and exercise periods.
Equity: In the context of a new business, the term “equity” refers to a share of the company’s ownership. At first, you, the founder, own 100% equity. After that, if you decide to have other co-founders, you can split the equity. You can learn more from our article “How to Split Equity in a Startup Fairly in 2023”
Vesting: How long does your employee have to delay until they can exercise all their stock options and any other conditions attached to doing so. This essentially means that he/she will have to wait until a specific date has passed before they can exercise any of their stock options.
Exercise: The moment when your employee purchases their vested options at the predetermined strike price to convert stock options into shares. Your employee needs to go through a vesting cliff to use the shares.
Vesting Cliff: This is the time when your employee can’t exercise their stock options. A one-year vesting cliff assures that your employees put in one year of work. After one year, they will hold 25% of their vested shares
Types of stock options common in the Startup world
Now let’s discuss the types of stock options. Two distinct forms of stock options are often offered to startup employees. Options include both ISOs (Incentive stock options) and NSOs (non-qualified stock options)
ISOs (Incentive stock options): Incentive stock options (ISOs) are granted only to your employees where they can buy the stock at a stick price to encourage them in long-term commitment and contribution.
ISOs (incentive stock options) also offer more favorable tax treatment compared to other forms of employee stock purchase plans. ISO holders do not need to report anything until the stock is sold. To receive the tax benefit, employees must meet specific obligations. The conditions are
selling ISO stock at least two years after the grant date and one year after exercising the options.