Startup Equity Explained: Why issue Stock Options instead of Shares?

Given the various complicated issues with stock options (and we’ve only scratched the surface here), why don’t companies just give actual shares that are subject to some sort of vesting schedule instead of stock options?

There are many reasons for issuing stock options instead of shares. We look at four important reasons in this article.

#1: Tax Issues From Receiving Shares

If the shares of a company have any real value (because the company is making a profit and/or because the company has received considerable investment), then issuing shares can have sizable tax implications.

Even shares that are subject to vesting are, for tax purposes, considered income that the recipient has to pay income taxes on. So, if those shares are potentially extremely valuable, the recipient is unlikely to be in a position to afford this income tax since they aren’t getting any extra cash from the company to pay off that extra income tax.

On the other hand, assuming the strike price for issued stock options is equal to or greater than the fair market value of the company’s common shares, there is no taxable income imputed to the optionee.

#2: Increased Corporate Governance Work

When someone receives shares instead of stock options, they must be taken into account for a wide range of official company matters involving shareholders and their official shareholder rights, including, but not limited to: stockholder voting, consents, information rights, dividends and distributions, dissent rights, etc. So, giving employees and other service providers shares instead of stock options can create a significant amount of time-consuming extra corporate governance work.

Since optionees don’t usually exercise any of their options until something significant is about to occur, such as a sale of the company or an IPO, giving stock options usually results in far fewer actual shareholders that a company has to deal with.

#3: Shares Never Expire (Options Usually Expire 3 Months After Termination)

Another important, if rarely discussed, reason why companies give stock options instead of shares, is that, as we mentioned in our first Stock Options article, even fully vested stock options usually expire automatically 3 months after the end of an employment/service provider relationship.

Suddenly finding themselves out of work, and usually without any visibility as to whether the company will actually end up being a success, many optionees choose not to spend the required cash to exercise their options (or simply forget to do so in time!). And once those options have expired, the company is then free to issue the same number of options to somebody else without having to potentially dilute the existing shareholders.

In contrast, once shares have been issued to a recipient and those shares have vested, those shares will never expire, and that individual will be a shareholder in the company, with all of the obligations and headaches involved, potentially forever.

#4: Stock Options Only Have Value if a Company Value Increases

Shares that are issued to a recipient may have some very real and potentially considerable value on the date those shares are received, even if the company’s value doesn't increase after that date. On the other hand, assuming that stock options are issued with a strike price equal to or greater than fair market value, then those stock options have no value on the day they are issued.

The idea is that, because of this difference, a recipient of stock options will have a strong incentive not just to stay at the company long enough to fully vest into those options, but also to do whatever is required to make sure the company becomes as valuable as possible during that time, thus making those options actually worth a lot of money.

Of course, this reason more easily applies to very early-stage companies. Once a business and its team increase in size, it’s not hard for an optionee to lose sight of the impact they are making on a valuation when they only see themselves as a small piece of the overall effort.

MGLS: Helping startups navigate stock options and employee benefits: Ask A Question or Schedule a Meeting/Call.

For those who want to know more about related topics, we have published articles on anti-dilution protections (here), whether startups should work with advisors (here), and common fundraising questions (part 1, part 2).

Disclaimer: This article constitutes attorney advertising. Prior results do not guarantee a similar outcome. MGLS publishes this article for information purposes only. Nothing within is intended as legal advice.