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Understanding Stock Options In Startup: What to Know about the 2 Types of Employee Options and their Amazing Potential

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.

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To learn more about other terms commonly used in venture capital,Β check out our complete VC Glossary.

Table of Contents

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Takeaways:

  • Options are shorthand for derivative assets, which means they get their value from the underlying assets. They allow employees to purchase a certain amount of stock from a company at a fixed price and within a specified time.
  • Understanding the role of stock option grants when calculating your total compensation package for a startup is essential.

What are the Types of Stock Options?

Stock options can refer to stock exchange-traded options or employee stock options.

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  1. Stock exchange-traded options allow investors to buy and sell financial instruments on an exchange. They are not stocks. They are, instead, contracts that permit but do not oblige investors to purchase or sell shares at a specific price and date. Options contracts that derive value through a company’s stock don’t require you to be an employee to purchase or sell. It’s unlikely that options contracts relating to early-stage startups will be made available on a public stock exchange, as they are likely not to share publicly traded price.
  2. Employee stock options 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. Founders and employees can own equity in a company still in its infancy. Employee stock options are not the type of shares you would find on a public exchange.

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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.

What types of stock options in startups are available?

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).

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There are several key differences between ISOs and NSOs. But here’s an overview:

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  • ISOs are a form of equity compensation that can only be granted to employees. It gives the employees the right to exercise or buy company shares for a specific exercise price once the options are vested. They are differentiated from other types of equity compensation by how they are taxed. Usually, taxes do not have to be paid when ISOs are exercised. Plus, preferential tax treatment may occur if certain requirements are met.
  • NSOs are another form of equity compensation offered to employees. However, taxes are paid both when you exercise your options and when you sell your options. This means you generally pay more taxes with NSOs than ISOs.

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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).

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RSAs and RSUs and grants of stocks, not options of stock, so you typically don’t need to exercise them.

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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 β€œrestricted” stock,since the shares cannot be freely transferred or traded, and therefore the company stays in compliance with securities laws.

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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).

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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.

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What should you look for in a startup stock options agreement?

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.

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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.

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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.

Total shares granted

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.

Types of options available

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.

Exercise price per share

Also known as the “strike cost,” the exercise price is the price you will pay for each share if you exercise your options.

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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.

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The FMV is the value of the stock at any given time. This FMV determines the exercise price for stock options offered to employees.

Option grant date

This is the date that determines when the agreement will go into effect.

Option expiration date

This is the date that your stock options expire. (Yes! Stock options do expire).

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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.

The date vesting process begins

This is the date that your stock options start to vest.

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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.

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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.

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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.

What happens if my startup goes public?

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).

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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.

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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.

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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.

What happens to my options if the startup that I work for is never made public?

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.

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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.

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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.

Understanding startup equity

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.

What common issues should I consider when discussing stock options with my business?

  • Stock options to offset lower wages: Working in a startup can often mean your wage is going to be below the market rate. Because they believe you can make a difference in the company’s success, your employer will offer you options to offset the lower salary. This kind of thinking is dangerous. If the company goes under, the stock options and subsequent shares will lose their value.
  • Know your percentage of ownership. Your new company may offer 10,000 stock options as part of its hiring process. The number 10,000 is not enough. Although 10,000 might seem high, how many stocks have been created? The opportunity to own 10,000 stocks is drastically different if you have 10,000 stocks (10%) versus 10,000 stocks (10,000,000) (0.1%). It is essential to know your exact percentage of ownership. You should also know the stock’s current market value and the last round’s valuation. This information will allow you to understand the price an informed and financially savvy investor would pay for the same piece of the company.
  • You are paying to exercise your stock option. Please review your Stock Option Plan carefully. This is commonly referred to as “consideration” in contract terms. It can be cash or deferred payments. No matter the situation, ensure you fully understand how your stock options are exercised. Consider what happens if your stock options are not entirely stable or acquired. You might be able to move on with your life. The vested shares must be exercised within a specific time after your departure. You will need to raise the cash to exercise your options or convert them into stock shares. Stock shares don’t have a time limit.
  • Triggers and success events. An Initial Public Offering or sale of a company is a Success Event. Check your stock option agreement to see if any provisions allow for accelerated vesting in the event of a successful event. If you have stock options that vest for four years but are still with the company after two years, your options may be accelerated to allow you to purchase the stock options before the 4-year vesting period expires.A trigger is a clause in your stock option agreement that allows your remaining stock options to be automatically accelerated upon the occurrence or continuation of a successful event. Some stock option agreements allow for acceleration at the discretion of the board. You can accelerate in total, meaning all unvested options are vested. Or you can accelerate partially. Your stock options should be accelerated. You contributed to the company’s rapid success, so you should have the chance to buy all of the stock in your option plan.
  • A single trigger vs. a double trigger: Last, there are two types of acceleration triggers. The single trigger is the most common. A single success event, such as a sale, either fully or partially accelerates your unvested stock options. The sale of the company is the most common trigger. Double triggers are less common and reserved for cofounders and executive employees. To accelerate vesting, you need to have two events.Two events are required to accelerate vesting. The first is usually the sale of the company. The second is the termination without cause of an employee. Each trigger will accelerate a portion of the unvested stock options. Double triggers are used to protect founders or executive staff who might be terminated in the event of an acquisition or merger. Make sure to understand the triggers associated with each stock option agreement.

Is there anything else you should know about Stock Options?

  1. You should understand the terms and conditions of the stock option agreement. The company should be transparent in ensuring that you are fully informed about the valuations and the number of outstanding shares.
  2. Stock options are granted in a variety of ways. It all depends on when you joined the company and your role. Initially, a company’s value is lower and is riskier to join. Management generally has larger stock options packages due to greater responsibility for influencing the company’s worth.
  3. Stock options and stock shares are not cash. Options are not worth anything unless they are converted into stock shares within the company. Stock shares are not as liquid as a bonus or wage rise.
  4. Stock options can be viewed as lottery tickets. If the company fails, the stock options will become worthless. It is important to remember that stock options are not meant to replace your salary.

Bottom line

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.

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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.

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