How Early Stage Startups Assign Employee Startup Stock Options

Of the many, many things that can be extremely confusing for a startup founder, how to assign startup stock options is undoubtedly near the top of the list. Stocks are a whole world unto themselves, complete with new vocabulary, confusing math, and complicated issues to consider.

If you're not already an expert in finance, chances are you're scratching your head and going “Huh?” while simultaneously trying to make it look like you definitely know what you're doing.

But have no fear! This is your very simple, “how to assign startup stock options” 101 primer. I've reached out to startup founders and financial experts to figure out how this all works.

Consider this your first step — and then consider buying some time with a financial expert so you can ask questions and work out the particulars for your business.

Because as much as I'd like to tell you that there's a tried and true way to assign startup auctions, the truth of the matter is that — like most things with startups — it's much more nuanced than that.

First, let's start with some startup stock option vocabulary

The following are some words that are going to come up in this article that you might not be familiar with if you've never thought about stocks until now.

If you're a little more informed, feel free to skip this section — I just figured I'd be nice and Google them all for you. (Unless there's a link, these definitions are from Google's dictionary.)

Cliff: “Cliff vesting is the process by which employees earn the right to receive full benefits from their company's qualified retirement plan account at a specified date, rather than becoming vested gradually over a period of time.”

Equity: the value of shares being issued by a company; “one's degree of ownership in any asset after all debts associated with that asset are paid off.”

Restricted Stock: “shares in a company issued to employees as part of their pay, but which cannot be fully transferred to them until certain conditions have been met.”

Shares: “a part or portion of a larger amount that is divided among a number of people, or to which a number of people contribute.”

Stock Options: “a benefit in the form of a stock option given by a company to an employee to buy stock in the company at a discount or at a stated fixed price.”

Strike Price (also known as Exercise Price): “the fixed price at which the owner of the stock option can buy or sell”

Vest: “Employees might be given equity in a firm but they must stay with the firm for a number of years before they are entitled to the full equity. This is a vesting provision.”

409A Valuation: “A 409A valuation is a formal report that tells you the value of your company's common stock.”

Stock Options: What Are They?

When you own a company, you have two types of ownership: common shares and preferred shares. Common shares give you voting rights and the right to make money when the company is sold or goes public. Preferred shares don't give you those rights but do give you a guaranteed rate of return on your investment — usually in the form of dividends paid out by the company.

Stock options give employees the right to buy common stock at a predetermined price (called the strike price). This right expires after a certain amount of time has passed or on an event that happens during that time period — such as when someone leaves or gets promoted within your company.

Stock Option Agreement

Before an employee can receive any options from their employer, they have to sign an agreement that outlines what happens if their employment ends prematurely. That's where stock option agreements come in.

A startup stock option agreement is especially important seeing as there isn't as much leverage to work with if things go south for any reason.

If an employee leaves before their stock option vests — i.e., before they have worked long enough to earn them — then they forfeit any unvested options they had. This means that if you quit after two months of working at a startup and haven't vested any options yet, then those are lost forever; however, if you quit after two years and haven't vested any options yet, then those are retained by the company until they vest or expire (usually four years after being granted).

What are the advantages of startup stock options?

Before we dive into the “how,” let's talk about the “why.” Considering the fact that most founders aren't financial experts and many have never founded a company before, why add the headache of figuring out startup stock options?

There are four main reasons why it's worth it:

Stocks can make up a gap between salary and market rate.

Startups can offer a lot to employees. The chance to work on something new and exciting. More flexibility in the workplace. “Casual Friday” every day. But one thing many startups can't offer is a salary that meets market rate.

Early-stage startups in particular might find it hard to attract and retain talented people; people who could be making a lot more money elsewhere. Offering stock options, then, can be a way to make up the difference between what you can pay them and what they should be paid.

Experts recommend that this gap be covered for generally around two years — but each company's mileage may vary.

“Generally the vesting deadlines are two years and up,” Cristian Rennella, founder of elMejorTrato.com, tells Startups.com. “My recommendation is to do it from three years onwards, because nowadays it takes more time for a company to reach a period of maturity and significant consolidation, especially in tech.”

One note about vesting: The monetary amount assigned to the stock options at the time of an employee being hired is the amount those options cost when they've gotten through their vesting period, regardless of the current value of the stock.

So if I get hired at DisruptingDisrupters (not a real company) this year and part of my compensation is 100 shares at 10 cents a share after a two-year vesting period, I have the option to buy those 100 shares for $1,000 once I've spent two years with DisruptingDisrupters.

If the value of the stock has dropped below 10 cents a share, I may or may not want to buy it. But if it's gone up to, say, 20 cents a share, I'm making money.

Stocks can help retain employees.

If you choose to vest your stock options — which means the employee isn't entitled to full equity until they've been with the company for a certain number of years — then offering startup stock options can be a good way to retain employees.

Needing to stick around for the full two or three years until they're vested could be the extra bit of incentive that people need to get through the rough patches that will inevitably occur.

Stocks can motivate employees.

A stock is a portion of ownership in a company and, for some people, being a partial owner is a great motivator for working even harder. People feel a greater sense of investment and pride in anything — a house, a business, a car — when they own it.

“To create ideal incentive systems for employees and founders alike, early-stage start-ups should transfer shares of the company to their employees and founders on a four-year vesting schedule with a one-year cliff,” Jennings Lawton DePriest, Director of Business Development at Canopy Software, tells Startups.com. “This schedule serves the dual purpose of incentivizing long-term commitment from employees and creating an ownership model that will be viewed favorably by outside investors.”

Incentive stock options

There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs may only be granted by smaller companies, while NSOs may be issued by both small and large companies alike. Both types can be used as part of an employee compensation plan or awarded as a form of equity compensation such as grants or restricted stock units (RSUs).

Stocks are relatively low-risk for employees.

“Stock options are great because employees participate in the upside without taking on any downside risk,”James Seely, head of Marketing at the ownership management platform Carta tells Startups.com. “If Mary gets a stock option when the strike price is $1 and the price goes up to $10, she participates in the $9 gain. If the price goes below $1, she has the option not to exercise (purchase the underlying shares), so she loses nothing.”

Restricted Stock Units

Restricted stock units (RSUs): RSUs are similar in many ways to ISOs but differ in one key respect — RSUs don't come with an exercise price or vesting schedule. Instead, they're issued right away when granted and become vested over time based on service criteria specified in each RSU grant agreement

The percentage method of assigning startup stock options

Assigning stock options based on percentage is relatively simple. You say “You, employee, own X% of this company.” So, if we throw some numbers in there, you could give an employee 1% of your company. If your company exits for $100 million, they would make $1 million. Pretty clear, right?

The problem with this method is that it becomes harder and harder to award percentages that would lead to any kind of meaningful return as you scale. Think about it: If you have more than 100 employees, you'd have to offer each one fraction of a percentage point.

And while so many of us would like to believe that our startup is going to be a unicorn, the truth of the matter is that it probably won't — and a fraction of a percentage point isn't going to be worth much.

The dollar method of assigning startup stock options

The other way of assigning startup stock options is “to think of equity in terms of dollar amount,” according to James.

“For example, 'I own 2,000 shares in Meetly, and investors paid $50/share in the most recent round of funding, so my equity is worth roughly $100,000 today,'” James says. “This allows founders and startups to make tangible equity offers to key hires.”

With this methodology, as the value of the company goes up, so does the value of each person's shares. Of course, if the value of the company drops, the employee doesn't get anything at all, but that's the risk with any method of distributing startup stock options to employees.

When should startups offer stock options?

So those are a couple of broad outlines of “how.” Now let's talk about “when.” James says that for the first five employees, the restricted stock makes sense.

“Startups can issue restricted stock in the early stages when the value of the shares is so low that the employees will not be taxed much,” he explains. “Beyond this point, it makes sense to start issuing stock options. Make sure you get a 409A valuation before issuing your first options.”

Broadly put, startups should offer stock options from the first employee until they choose not to anymore. Less broadly, you can go one of two different ways: offering stock options up until you can afford to pay your employees a market-rate salary and then stopping including that as part of the offer or continuing to offer stock options as a part of a compensation package into perpetuity.

The first option has the advantage of not diluting your company's stock; the second has the advantage of giving people a sense of ownership in the company. It's really up to you and your and co-founders how you want to do it.

What are the disadvantages of startup stock options?

So we've covered the “why,” the “how,” and the “when.” Now let's talk about the “why not.” The first reason? Stocks are really tricky.

“The first disadvantage of stock options is that they are complicated and most employees require a base level of education to understand them,” James says. “Many of the companies we work with at Carta invest in educating new hires and periodically host training sessions for existing employees.”

Another disadvantage? Changing tax codes.

“The second disadvantage is that stock options are subject to the tax code, which can change at any time,” James says. “A recent proposal would make it so that stock options are taxed at vest instead of exercise. That would mean that every year you vest new shares, you would have to pay taxes on the gain in Fair Market Value, even though your shares are illiquid and you might not have the cash on hand to pay those taxes.”

Another disadvantage is that stock options are basically worthless — or maybe a better way to say that is that their value is largely symbolic — until the company is traded publicly or purchased by another company. So offering them even after it appears that your company might not make it to that point is kind of a jerk move.

Also, if you give away stock options too freely, you can dilute the value of your company. This is an area where it would be a good idea to talk to a financial adviser about structuring what percentage of your stock you want to allocate for investors, employees, and advisers.

So there you have it! Your primer on startup stock options. Now go out and hire a financial advisor, for a least an hour or two. Seriously — there are some things you really should pay an expert for.

Also worth a read:

1. Founder Compensation: The Good, the Bad, and the Suicidal

2. Everything You Know About Startup Equity Distribution is Wrong

3. How to Use Your Product, Not Perks, to Attract Talented Employees

4. How to Figure Out Non-Insurance Benefits for Employees