How Employee Stock Options Work in Startup Companies

Stock Option Plans are an extremely popular method of attracting, motivating, and retaining employees, especially when the company is unable to pay high salaries. A Stock Option Plan gives the company the flexibility to award stock options to employees, officers, directors, advisors, and consultants, allowing these people to buy stock in the company when they exercise the option.

Stock Option Plans permit employees to share in the company’s success without requiring a startup business to spend precious cash. In fact, Stock Option Plans can actually contribute capital to a company as employees pay the exercise price for their options.

The primary disadvantage of Stock Option Plans for the company is the possible dilution of other shareholders’ equity when the employees exercise the stock options. For employees, the main disadvantage of stock options in a private company—compared to cash bonuses or greater compensation—is the lack of liquidity. Until the company creates a public market for its stock or is acquired, the options will not be the equivalent of cash benefits. And, if the company does not grow bigger and its stock does not become more valuable, the options may ultimately prove worthless.

Thousands of people have become millionaires through stock options, making these options very appealing to employees. (Indeed, Facebook has made many employees into millionaires from stock options.) The spectacular success of Silicon Valley companies and the resulting economic riches of employees who held stock options have made Stock Option Plans a powerful motivational tool for employees to work for the company’s long-term success.

How does a stock option work?

The following shows how stock options are granted and exercised:

ABC, Inc., hires employee John Smith.
As part of his employment package, ABC grants John options to acquire 40,000 shares of ABC’s common stock at 25 cents per share (the fair market value of a share of ABC common stock at the time of grant).
The options are subject to a four-year vesting with one year cliff vesting, which means that John has to stay employed with ABC for one year before he gets the right to exercise 10,000 of the options and then he vests the remaining 30,000 options at the rate of 1/36 a month over the next 36 months of employment.
If John leaves ABC or is fired before the end of his first year, he doesn’t get any of the options.
After his options are “vested” (become exercisable), he has the option to buy the stock at 25 cents per share, even if the share value has gone up dramatically.
After four years, all 40,000 of his option shares are vested if he has continued to work for ABC.
ABC becomes successful and goes public. Its stock trades at $20 per share.
John exercises his options and buys 40,000 shares for $10,000 (40,000 x 25 cents).
John turns around and sells all 40,000 shares for $800,000 (40,000 x the $20 per share publicly traded price), making a nice profit of $790,000.

Why do companies issue stock options?

Companies issue options typically for one or more of the following reasons:

Options can be used to attract and retain talented employees.
Options can help motivate more dedication from employees.
Options can be a cost-effective employee benefit plan, in lieu of additional cash compensation.
Options can help smaller companies compete with larger companies in attracting great employees.

Key issues in stock options

A company needs to address a number of key issues before adopting a Stock Option Plan and issuing options. Generally, the company wants to adopt a plan that gives it maximum flexibility. Here are some of the important considerations:

Total number of shares: The stock option plan must reserve a maximum number of shares to be issued under the plan. This total number is generally based on what the board of directors believes is appropriate, but typically ranges from 5% to 20% of the company’s outstanding stock. Of course, not all options reserved for issuances have to be granted. Also, the investors in the company may have some contractual restrictions on the size of the option pool to prevent too much dilution.
Number of options granted to an employee: There is no formula as to how many options a company will grant to a prospective employee. It’s all negotiable, although the company can set internal guidelines by job position within the company. And what is important is not the number of options, but what the number represents as a percentage of the fully diluted number of shares outstanding. For example, if you are awarded 100,000 options, but there are 100 million shares outstanding, that only represents 1/10 of 1% of the company. But if you are awarded 100,000 options and there are only 1 million shares outstanding, then that represents 10% of the company.
Plan administration: Although most plans appoint the board of directors as administrator, the plan should also allow the board to delegate responsibilities to a committee. The board or the committee should have broad discretion as to the optionees, the types of options granted, and other terms.
Consideration: The plan should give the board of directors maximum flexibility in determining how the exercise price can be paid, subject to compliance with applicable corporate law. So, for example, the consideration can include cash, deferred payment, promissory note, or stock. A “cashless” feature can be particularly attractive, where the optionee can use the buildup in the value of his or her option (the difference between the exercise price and the stock’s fair market value) as the currency to exercise the option.
Shareholder approval: The company should generally have shareholders approve the plan, both for securities law reasons and to cement the ability to offer tax-advantaged incentive stock options.
Right to terminate employment: To prevent giving employees an implied promise of employment, the plan should clearly state that the grant of stock options does not guarantee any employee a continued relationship with the company.
Right of first refusal: The plan (and related Stock Option Agreement) can also provide that in the event the option is exercised, the shareholder grants the company a right of first refusal on transfers of the underlying shares. Doing so allows the company to keep share ownership in the company to a limited group of shareholders.
Financial reports: For securities law reasons, the plan may require that periodic financial information and reports are delivered to option holders.
Vesting: How do options vest? Most companies provide a vesting schedule, where the employee or advisor has to continue to work for the company for some period of time before the optionee’s rights vest. For example, an employee may be awarded options to acquire 10,000 shares with 25% vested after the first full year of employment, and then monthly vesting for the remaining shares over a 36-month vesting period.
Exercise price: How much does the optionee have to pay for the stock when he or she exercises their option? Typically, the price is set at the stock’s fair market value at the time the option is granted. If the stock’s value goes up, the option becomes valuable because the optionee has the right to buy the stock at the cheaper price.
Time to exercise: How long does the optionee have the right to exercise the option? The Stock Option Agreement typically sets a date when the option must be exercised (the date is usually shortened on termination of employment or death). Most employees only have 30-90 days to exercise an option after their employment with the company has terminated. This can be burdensome, particularly since the optionee may not have been able to sell any of the underlying shares to help pay the tax resulting from the exercise of the option.
Transferability restrictions: What restrictions apply to the transfer of the option and underlying stock? Most Stock Option Agreements provide that the option is nontransferable. The agreements also state that the stock purchased by exercising the option may be subject to rights of purchase or rights of first refusal on any potential transfers. Increasingly, companies desire to implement more robust restrictions on both the options and the shares received upon exercise of the options to limit trades in the secondary market that may cause practical concerns in managing holders of the company’s stock.
Securities law compliance: The issuance of options and underlying shares requires compliance with federal and state securities laws. Experienced corporate counsel should be involved here.
409A valuation: The company needs to make a determination of the fair market value of its common stock in order to set the exercise price of the option, pursuant to Section 409A of the Internal Revenue Code. This is often done by hiring a third-party valuation expert.
Cash usually needed: To exercise an option, the option holder typically has to pay cash out of pocket for the exercise (very few companies allow “cashless exercise”).
ISOs: An employee holding tax advantaged Incentive Stock Options (ISOs) does not have a tax (or tax withholding) event upon exercise. You report taxable income when you sell the stock, but will need to include the difference between the exercise price and the current fair market value at the time of exercise (the “spread”) in income for purposes of calculating any additional tax obligation under the alternative minimum tax rules. If certain holding periods are met before selling the stock, all of the gain (back to the exercise price) may be taxed at the more favorable long-term capital gain rates.
NSOs: If the options are not tax advantaged ISOs, they are “non-qualified stock options” (NSOs), and the spread upon exercise will be taxed at the more unfavorable ordinary income rates (as opposed to the capital gains rates). Additionally, as the exercise date is a taxable event, the company will have to report the spread as taxable income on the employee’s Form W-2 in the year of exercise and withhold applicable taxes on the amount of the spread, which generally means that the employee will have to write a check to the company to cover the tax withholding liability.
Illiquidity: Stock in privately held companies is typically not liquid and is difficult to sell.

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