Stock options are the gateway to prosperity for startup employees. Of course, folks want them! And the more successful the startup is, the more stock options they want.
Stock options can also be a major headache for founders and boards. In fact, in cases where the startup’s trajectory isn’t so smooth, stock options can be a source of major contention among employees and investors alike. And if the startup doesn’t work out, then each employee’s stock option agreement is nothing more than a shattered dream.
Bottom line, stock options are truly a blessing and a curse for founders and their early-stage employees. Let’s dig in, learn more about stock options and how good planning can reduce potential headaches for everyone.
A stock is a unit of ownership in a corporation. Shares of stock are issued (i.e., an equity issuance) by a corporation and sold to stockholders as a means to raise capital. Stockholders are fractional owners of the corporation. Their equity (i.e., shares of stock) can rise and fall in value depending on a variety of factors, including the corporation’s financial performance, perceived opportunities for future growth, and the size of the market in which it operates. There’s no limit to how far the share price could rise, but there’s also no limit to how far it could fall, meaning shares of a corporation, especially a startup, have a very high likelihood of falling to $0. In other words, stockholders could lose all their money.
A stock option is an opportunity, but not an obligation, for its holder to purchase shares of stock in the corporation that issues the option for a specified price. Stock option agreements are commonly issued by startup companies to create a very strong incentive for employees to contribute maximum effort in helping scale the company (and thus increasing the value of the startup and its stock).
Stock option agreements will come in two forms: incentive stock option agreement (ISO) and non-qualified stock option agreement (NQSO). ISOs can only be issued to employees, while NQSOs can be issued to other parties – individuals or entities – related to the company. ISOs and NQSOs have different exercise time periods and notably different tax implications.
But, both types of stock option agreements will have a few key components to them, along with plenty of other legal provisions:
The last two points are worth further consideration. Vesting is a means by which startup companies can compel their employees to commit to the startup. It is fundamentally a motivational tool. You don’t get all your options on day one. Options will likely vest in installments over three-to-five-year periods, provided employees remain gainfully employed with the startup. Vesting requires employees to stay and (let’s be honest here) grind it out to earn the total number of options stated on the vesting agreement. Otherwise, unvested options are forfeited and returned to the company.
Equally important to the vesting period is the period after an employee’s employment ends by which they are required to purchase the vested options. Employee holding an ISO have three months to exercise his or her options, meaning that if an employee doesn’t exercise the option to purchase the vested shares within that time period, the options are forfeited and returned to the company.
But here’s the catch, you don’t just say, “I want to my exercise my options, kindly send my stock certificates.” The option holder must PAY for the shares at the stated strike price. This brutal fact often catches people by surprise because the purchase price can be significant.
For example, if you are lucky enough to have vested 50,000 options to purchase company stock at a strike price of $2.00 per share, and you want to exercise your options after leaving the company, then you need to present the company a check for $100,000.00 to purchase illiquid securities.
Now, if the value of the company has gone higher, perhaps even notably higher that your strike price, then there’s a good reason to exercise your options. But, many folks, regardless of age, do not have that much capital lying around. Moreover, if you do have the capital and choose to exercise the options, shares of startup company stock are highly illiquid. You can’t turn them around and sell them on a brokerage account with the same speed as you can dispose of your Apple stock (there are some secondary markets for the best of the best startups, but it safe to assume most startup stock is highly illiquid).
Like I said, stock options are a blessing and a curse.
Stock options don’t just magically appear. Founders cannot simply decide to whom and when they want to issue stock options. And there definitely is not a stock option stork.
Stock options are created under the authority of the company’s board of directors and within the parameters set forth by the company’s governing documents, namely the stockholder’s agreement and the charter, which is the document that defines the classes of stock you can issue and the total number of authorized shares.
The board of directors will need to adopt and approve (i) a stock option plan, (ii) the size of the designated pool from which options can be granted, (iii) a form of stock option agreement, and (iv) the means by which stock option grants are approved. Some boards may want to approve all grants, some may create a stock option committee for the purpose of approving grants up to certain thresholds.
The board will also take careful consideration to think about the stock option grants that founders receive. Just as the founders will want to motivate their employees to stay and exert significant effort in scaling the company, the board will want to infuse the same motivation in the founders. Founders should be a significant option holder, because, and keep this last point in mind, it can be a useful tool to fight against your own dilution as you raise capital.
All that said, it is very important for founders to get to work with their counsel and board early and build a sound stock option plan.
The first step in building a sound stock option plan is making sure everyone agrees on the importance of stock options. As founders, you want to make sure your board is fully supportive of the need to issue options in order to attract and retain top talent. Likewise, a board will want founders to be bought into the concept of receiving part of their equity through options, thus compelling the founders to stay.
With everyone on the same page, the next step will be to make sure you hire great legal counsel who has significant experience building stock option plans for startup companies. There are a lot of federal and state laws and a lot of tax implications around stock options, so I cannot stress this point enough: HIRE GREAT COUNSEL!!!
A great law firm will help you with the many procedural aspects of building a plan. But one critical decision will be left up to the founders: how big do you want to make the stock option pool?
This size of the pool will determine a lot of things, from how many options you can grant per employee to how long the pool will last to how future investors will view your cap table.
Before rushing in to determine pool size, take time and open up some blank excel tabs to model out what your cap table and stock option pool will look like over time. This exercise is critical because issued options have the potential to become issued shares of stock, thus impacting the ownership percentage of everyone in your cap table. Investors will take your stock option pool – and its potential dilutive impact – into account when valuing your company. But, you don’t want to make the stock option pool too small, because then you may not have enough options to issue to employees – especially those critical c-level hires that will demand significant stock option grants – and get caught in the pickle of having to go back to your board and ask to increase the size of the pool. Boards won’t want to be asked often, because each time the pool is enlarged, the board members, many of whom are likely investors, are diluting their own ownership interests.
What’s a good size for a stock option pool? I’ve seen 20% as a common size, which means the pool of stock options, if every option were exercised, would represent about 20% of the overall ownership of the company. Some option pools are smaller. I’ve seen a few companies with 10%, which may work fine if founders have significant ownership interest and the headcount is unlikely to grow rapidly (or only a certain subset of headcount will partake in the plan).
But as a founder, I’d lean towards getting everyone on board with a number that is close to 20% and have a clear plan for how the stock option pool will be refreshed over time. Here’s why:
Spend some time building a good stock option plan and creating a clear framework for stock option issuance to employees based on their level and role within the organizational structure. Map it out, work closely with your lawyers, and make sure your board is on board!
You’ve built a good stock option plan. Now let’s get to work issuing some stock options!
The most important thing to consider when issuing options is the strike price. Why? Because it is the thing that can get you in the most trouble.
ALWAYS be sure you are issuing stock options for the appropriate value. Since the value of your company will likely grow, the strike price of your stock options will grow over time, too.
Consult your legal counsel on this point and whatever you do, take their advice! Sometimes, the appropriate strike price can be set by a recent sale of company stock. More often, though, you’ll want to engage an independent third party on a routine basis (i.e., semi-annually or annually) to conduct a formal valuation of your company to determine the right strike price for your stock. These valuations are commonly called 409A valuations (taking their name after the provision of the Internal Revenue Code that governs deferred compensation), and they will be critical to keeping your stock option issuances on track.
Once you identify the right strike price for the issuance of options, you must figure out who is getting options and how many options they are getting.
Do yourself a favor: do not make this an ad hoc exercise. Build that framework and stick to it. Why, you ask?
With the price established and the option amounts determined, make sure you follow the appropriate protocols for (i) approval of the option grants, (ii) determining whether to issue ISO’s or NQSO’s, (iii) executing the option agreements, (iv) recording the option agreements in your cap table and corporate files, and (iv) making the appropriate tax elections (I’m looking at you, 83(b) election!).
In other words, make sure you work closely with your legal team on this process. Your legal team should co-manage it with you to stay in compliance and ensure your option pool and cap table are in tip-top shape for your next capital raise.
Because we all know the next capital raise will be here sooner than you think!
In no time, your company will be growing and so will your cap table. As a result, your stock option pool will likely be dwindling as you issue more and more stock options. There are a few things you will want to consider.
First and foremost, you will want to bring in the right software tool, especially before your stock option pool gets too big, to address stock option administration. Carta, a startup itself, is a common tool used by many startups, but there are others out there. Ask for recommendations, take a few for a test drive, negotiate pricing, and make your pick. A quick tip: better to do this earlier than later. Later may mean a lot of time and coordination with your law firm (re: fees!) to implement your chosen software.
Second, as we discussed above, there will come a time when you need to expand the stock option pool to meet the needs of your growing company. This means going to the board and asking the board to increase the size of the pool in accordance with the requirements of the company’s current stockholder’s agreement and charter.
When you make the ask to increase the pool, there are a few items worth considering:
The illiquidity of startup company stock becomes a moot point when a startup goes public. Employees will typically have to hold onto their company stock for 6 months following an initial public offering. Thereafter, those stock option grants can become a true blessing.
But as the title of this post suggests, stock options can be a blessing and a curse. For founders and for employees. Two other exits can produce much less prosperous outcomes.
One outcome is obvious. If the startup fails, then everyone’s interest in the company, from option holders to stockholders, is worthless. Not what anyone wants, but history offers a cold truth: failure is the most likely outcome when building a startup.
The other outcome is less obvious. It represents the ultimate curse for option-holding employees. If the company is acquired, employees’ options may not have any value. In a scenario where a startup company has issued common stock and one or more preferred classes of stock (Series A, Series B, etc.), it is critically important to remember that stock option plans are designed to provide employees with the opportunity to purchase common stock. Common stockholders only benefit in a sale once the rights of all preferred shareholders are satisfied. If a startup has multiple classes of preferred stock, each with liquidation preferences, then a scenario could emerge where the preferred stockholders make a profit without the common stockholders seeing any benefit.
In that instance, stock options can be a curse. Especially in an environment where startups have raised a lot of capital at high valuations over the past few years. Acquisitions in the proceeding years may happen, but not at the valuations founders want, which could result in a substantial portion of proceeds going to preferred shareholders, leaving little if anything for common shareholders.
For founders, you will always shoot for the moon. You must recruit investors, employees and customers alike with the confidence that you will make it there. Set up your stock option plan to enable you build the right team and motivate your team to help you make it to the moon!
For employees, this means you must proceed into any startup with a clear and open mind. Interview carefully, research the fundraising history, and understand the trajectory of the startup you are joining. Do your own sensitivity analysis on future growth. Ask a lot of questions of your founders when negotiating stock option packages. And most importantly, head to work every day with the emotional elasticity to understand stock options can be a blessing and a curse!