What Are Stock Option Grants?
Is it that time of year again? Time for new hires and issuing options, that is! If you’ve just extended offers to employees, or are about to, the inevitable discussion about salary and equity is bound to come up. While most employees tend to focus on the former, since it is a more tangible source of income, having an option grant in a startup can be extremely valuable if the startup is successful. Although your new employees are undoubtedly already qualified for their role at your company, they might not feel as comfortable when it comes to understanding the equity you have granted them. Not to worry—that’s why we put this post together, to clarify just what “accepting options” really means.
Understanding Stock Options
When a company is first formed, founders usually own the entirety of the company’s issued shares, and bit by bit they begin to expand their cap table by selling shares in the company. During this process of growth, a portion of the company’s shares are saved for employees at the company. This pool of shares is commonly referred to as the “option pool.” Essentially, the pool is a limited number of shares available for company executives to grant to their employees and other service providers.
Most employees at a startup company are offered stock options. A stock option is a promise from the company to the individual that helps assure the individual that they can purchase a set number of shares at a predetermined price (the “strike” or “exercise” price) in the company. These options serve a twofold purpose for the company: they help ensure that employees’ goals align with the company (as the worth of the option grant depends on the success of the company) and are a way of providing additional compensation to make their employment offers more competitive.
Accepting Stock Option Grants
Just because you've sent along an option grant and the employee has signed the paperwork does not yet mean that they own a piece of the company. The majority of stock options are subject to “vesting”—which doesn’t mean that the stock is dressed like a Patagonia model—rather, “vesting” is part of the “incentive” piece of the option grant. So while an employee may have a bunch of options in the company, they probably haven’t vested yet (remember, a startup needs employees to put some sweat behind the equity before they can reap the benefits).
Unvested options need to vest before you can buy them, and this is a process that can often take years. The “vesting schedule” of option grants will indicate just how long an employee might want to stick around in order to get the entirety of their promised options, but a common scenario is an option grant with a 1-year cliff and subject to 4 years of monthly vesting. In this case, they won’t actually see any of their options until one year after their grant date, wherein a fourth of the options they have been granted will “vest.” Then, for the next four years after that initial year, they will receive a few more options every month.
Once the grant has vested, they still don’t own anything in the company. Rather, they now own the option to purchase these shares. The jargon for actually buying these shares is termed “exercising options.” When it comes to exercising options, employees need to spend some money before they can actually make some money.
To determine just how much they will need to spend, multiply the option grant strike price by the number of shares being exercised. You will also want to consider any income tax that may be applicable. The strike price is set out when the employee was first offered the option grant, but the taxable component will vary (consult with a tax professional to better understand your particular situation).
The moment an employee decides to exercise options is really up to them. As long as they continue to be employed by the company, the option to purchase shares is entirely their decision. They can exercise them all immediately, and before they vest if the grant allows for “early exercise,” or exercise them in bunches, or wait until they leave the company to complete the exercise of the options. However, if they leave the company, they typically have only 90 days after the last day on the job to exercise these shares, and there could also be tax disadvantages for waiting so long, depending on circumstances.
After they have exercised the options, they have a stake in the company (since they have bought shares). Although being a stockholder doesn’t make you a billionaire overnight, because you can’t sell shares on a public market, when a company exits (i.e. is acquired by another company or decides to undergo an initial public offering) it's possible to make a significant profit.
How Do Employees Make Money?
Without an exit (either an acquisition or an IPO), the option payout is zero. In some cases, purchasing options at a company that never has an exit can lose money instead of make money. That being said, if a startup does have a successful exit and its value is high, employees can make a large profit on their initial investment.
In other words, when they were first granted the options, the strike price was probably very low because your company’s potential hasn’t been established yet. Then, after disrupting the industry the company exists in, the value of each share increases. Suddenly, the initial payment pales in comparison to the amount of money you may receive for these shares, and everybody can be happy and rich.
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Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.