Stock options in startups can be one of the most lucrative but often misunderstood opportunities for early-stage startups. Options can offer substantial rewards in terms of returns on contracts and the ultimate goal of a higher equity stake in the startup when it develops, expands, and enters mature stage growth.
To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.
Stock options can refer to stock exchange-traded options or employee stock options.
When people refer to “startup stock options,” it is the 2nd type of option. Employee stock options are granted to employees in a startup.
If you spend any time in Silicon Valley, employee stock options will be a common form of startup equity compensation. However, not all employee stock options will be the same as different startups might offer different options for different startup employees.
We’ve now narrowed down our focus to employee stock options. Let’s take a look at two types of stock options that are commonly granted to employees in early-stage startups. These are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).
There are several key differences between ISOs and NSOs. But here’s an overview:
Apart from ISOs or NSOs, a startup may have a cap table with equity types that don’t include stock options. These include common stock, preferred stock, Restricted Stock Awards (RSAs) and Restricted Stock Units (RSUs).
RSAs and RSUs and grants of stocks, not options of stock, so you typically don’t need to exercise them.
RSAs grant you company stock with restrictions. While the shares you accept will be owned by you on the date you accept, the shares will generally be subject to vesting conditions.
RSAs are considered “restricted” stock,since the shares cannot be freely transferred or traded, and therefore the company stays in compliance with securities laws.
RSUs, aside from stock options, are the most common equity type you will encounter as a startup worker. Instead of allowing you to buy the stock at a specific price and date, RSUs convert into common stock once certain conditions are met (employee is vested, employee has achieved performance milestones, etc).
These RSUs have no value until they are vested and then they are assigned a fair market value (FMV). Then they are considered income and a portion of the shares are withheld to pay the taxes and the remainder is given to the employee who has the right to sell them.
Option grants or stock option agreements can be crucial to startup hiring. A startup stock options agreement, also known as an option grant, is precisely what it sounds like. It’s an agreement between a startup company and employees that details all the options they will be granted.
The stock option agreement you sign is different from your offer letter. While your offer letter may contain information about the options included in your compensation package, the option grant is an independent document you should carefully read and sign before you start your employment. You are technically not entitled to your options if you don’t sign the option grant.
Attention: You should know that the option agreement is typically signed within a few hours of receiving the offer letter. There may be a short delay between the time you receive the offer and the time you receive your grant.
The total number of shares you are entitled to buy with your options should be clearly stated in the option grant. This is not the total number of shares you will receive but the number you can buy if your options are exercised.
It is essential to specify what options are being granted in your grant. It’s common for early-stage startups to reward employees with ISOs and NSOs. This is why it’s essential to understand how they differ, especially in tax implications.
Also known as the “strike cost,” the exercise price is the price you will pay for each share if you exercise your options.
When you grant your option, the fair value of your company’s stock is used to determine the exercise price. Before offering equity to employees, startups and private companies must submit a 409A appraisal. This is an independent, objective assessment of the value of their common stock.
The FMV is the value of the stock at any given time. This FMV determines the exercise price for stock options offered to employees.
This is the date that determines when the agreement will go into effect.
This is the date that your stock options expire. (Yes! Stock options do expire).
This date is important because stock options lose value after their expiration date. The agreed-upon exercise price can be used to exercise your options up until now. After that, the same options will cease to be valid.
This is the date that your stock options start to vest.
Understanding vesting is essential because many companies offer equity contingent upon a vesting schedule. This means you won’t get all your options or shares immediately; you will need to wait for a specific period or meet certain benchmarks.
Many grants have language that describes a one-year vesting period or “vesting Cliff.” Your options will not vest until you’ve been with the company for at least one year. Your options could vest more frequently after the cliff.
Startups are used to a four-year vesting schedule. However, it would be best if you did not assume any responsibility until it is clearly stated in your grant.
A startup can go public in many different ways. A startup can raise money through an initial public offering (IPO) or be listed directly. Or it could go public via a special-purpose acquisition company (SPAC).
These are all examples of an exit strategy and liquidity event. Early investors and shareholders can convert their illiquid shares into real dollars. Your company’s shares will be traded on the stock exchange in the event of a liquidity event. Your options will have a value tied to the stock’s current market price and fair market value.
The difference between the strike price and the current stock price determines your options’ value. Your options are worth something if the current stock price is higher than the strike price. If the reverse is true and your strike price is more than the stock’s current price, then your options aren’t worth anything, and you shouldn’t exercise them.
Many factors can influence when your company goes public, including your tax treatment. These factors can be quite complex and depend on individual circumstances. We recommend consulting a financial advisor or tax advisor to help you.
Your options may be limited if the startup you work at never goes public. However, this doesn’t mean your options are limited. You can also have a direct acquisition by another company or private equity group.
These events could offer you the opportunity to cash out your options or substitute your options with equity awards from the new company. Every case is different, and each case will be handled differently.
Your options could be treated differently depending on whether they are vested. Before you decide on a course of action, understand what your options will look like.
Options are integral to many startup compensation packages and can be a significant incentive to choose one company over another. There are no guarantees in the world. Remember that every successful startup that goes public is not the only one whose equity might not be worth as much.
Regarding stock options for startups, one of the most important things to remember is to have patience, resolve and believe in the startup. Employee stock options can be a lucrative, financially rewarding part of a comprehensive compensation program.
However, holders of ESOs should be well acquainted with their company’s stock options plan as well as their options agreement to understand any restrictions and/or clauses. Discussing your options with a financial planner or wealth manager to gain the maximum benefit of this potentially high rewarding component of compensation would be advised.
An operating agreement is a legal document used by companies to define their organizational structure, roles and duties of owners and other key parties involved in the business, and methods for handling all transactions that occur within the company.
Stock options in startups work as a form of equity payment that allows an employee to purchase a certain number of shares of company stock at a specified price.
An over-allotment option allows companies to issue extra shares of their stocks beyond those that they initially planned or announced when they go public (or offer other securities). It’s also known as a “greenshoe option”.
Participating preferred stock is a type of preferred stock that gives the holder the option to receive dividends equal to or greater than the customarily defined rate at which preferred dividends will be paid to preferred shareholders.
