Startup Equity Explained: What are Stock Options?
• Stock options are the right to buy shares from the company that issued them at a specific price (called the strike price), usually tied to the market value of the shares when stock options are issued
• Stock options are a popular type of equity compensation for startup employees and other team members (advisors, contractors, etc.).
• Having stock options is a great way to offer employees a lower salary than they might expect elsewhere, in exchange for a future when they will potentially own shares in the company and can benefit from an exit (such as the sale of the company or even an IPO).
• Equally important, stock options give your team a sense of ownership
• Depending on the ultimate value of a company’s shares at an exit versus the strike price, stock options give employees the opportunity for a potentially huge windfall – the dream of so many startup employees.
Let’s take a closer look at stock options, how they work, and when they become valuable for employees that hold them.
Giving early-stage hires equity compensation is often the best solution for new businesses that are low on cash, compared to established businesses, and want to incentivize key team members. Equity compensation ensures they are invested long-term in the company while saving on salaries and bonuses the company can’t afford.
And for these early-stage team members, equity compensation is often the holy grail – the chance to own a percentage of a company that could one day be worth many millions, or even billions of dollars. Over the decades, tech giant equity compensation has created thousands of millionaires.
Stock options are the most common form of equity compensation. And probably everyone who is working or even thinking about working with a startup has heard that term. But if you’re not familiar with the details, here are some key points you definitely should know.
Stock Options vs. Shares: Explained
First, and most importantly, stock options are not shares.
Instead, stock options are the right to buy shares at a certain fixed price (known as the strike price). A recipient’s ability to buy shares by using their options – to “exercise” their options -- depends on a vesting schedule for those stock options that’s set out in the legal documentation when the options are issued.
Because stock options are not shares and recipients – also known as optionees -- are not shareholders in the company, an optionee doesn’t get any of shareholder rights until they exercise the options to purchase shares at the pre-agreed price. Until that happens, an optionee doesn’t have any shareholder voting rights, doesn’t have to be taken into account for any matter requiring shareholder approval, doesn’t have any dividend rights, or any other shareholder rights.
Who Gets Stock Options; Who Issues Them?
While a company can hypothetically issue stock options to anyone, stock options are almost always issued to individuals providing services: employees, advisors, consultants, and sometimes also directors.
Practically speaking, stock options are issued by corporations. For various tax and securities law reasons, if your business is not legally a corporation, it would be very unusual for your business to issue options. Instead, other types of legal entities usually use other ways to provide equity compensation (for example, LLCs commonly issue profits interest units).
How Do Stock Options Gain Value?
An optionee will get a grant of stock options by way of a legal agreement with the issuing company that’s usually called a stock option agreement.
That agreement will set out the strike price – the amount an optionee must pay in cash per share in order to purchase one share. For tax reasons, the strike price almost will almost always be equal or greater than the fair market value of the company’s common shares as of the date the stock option is officially granted. Theoretically, at least, the stock options aren’t worth anything on that date, since the strike price will be equal or greater than the market value of a common share.
This changes as the company increases in value. When that happens, the fair market value of a common share will be greater than the strike price. At that point, the stock options have real value – either because they allow an optionee to purchase common shares at a discount relative to their current market value, or because an optionee could hypothetically sell their options to someone interested in buying.
What’s a Vesting Schedule?
Stock option grants always include a specific number of stock options – that’s the maximum number of stock options an optionee will get from that specific grant.
However, since stock options are normally used as to incentivize and reward a long-term commitment to a business, stock options are almost always awarded with a vesting schedule. This means that a certain number of options vest every month, quarter, or year depending on the specifics of the vesting schedule. If an optionee’s employment/service provider relationship with the startup ends, that optionee’s vesting will end, and the optionee will have the right to exercise only that number of options that have vested as of the termination date.
Currently, the most common vesting schedule for startups is a 25% vesting cliff on the 1st anniversary of the vesting start date, with the remaining options vesting in equal monthly portions over the next 3 years.
For example, with this schedule, if an optionee received a stock option grant for 4,800 shares with this schedule, stock options to purchase 1,200 shares would vest on the 1st anniversary of the vesting start date, and an additional 100 shares would vest on each subsequent monthly anniversary of the vesting start date until all the options have vested.
When Will The Stock Options Expire (Usually 3 months After an Optionee Leaves the Company!)?
Generally speaking, stock options have a maximum legal life span of 10 years. Important to note, however, almost every company has language in their stock option agreements that says that an optionee’s stock options vested and unvested stock options will automatically expire at a certain point in time. And deadlines usually applies regardless of who terminated the relationship or why.
All unvested stock options will expire immediately upon termination. Vested stock options will usually expire 3 months after termination regardless of who terminated the employment/service provider relationship or, unless the termination was for cause, why. The specific details and timeline will be set out in a company’s stock option plan, and an optionee’s stock option agreement.
Exceptions to the ‘3 month’ rule: in the event of an optionee’s disability or death, that post-termination exercise period is commonly extended by a few months. Also, stock option agreements frequently stipulate that, in the event an optionee’s employment/service provider relationship was terminated for “Cause” (however that is defined in the stock option agreement), all vested stock options also immediately expire upon termination.
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.