A stock option in a startup is a form of equity compensation that enables employees to buy company shares in the future at a fixed price, usually the current fair market value. This compensation is often given to motivate and reward employees, providing them with the opportunity to profit from any future growth in the company’s value.
How Stock Options Work
When an employee is granted a stock option, they are given the right to buy a specific number of shares at a fixed price, also known as the exercise price or strike price. The strike price is generally the fair market value of the shares at the time of the grant.
For example, suppose an employee receives 10,000 stock options with a strike price of $1 per share. If the company’s stock price increases to $5 per share and the employee exercises their options, they can purchase 10,000 shares for $1 each ($10,000) and sell them on the open market for $5 each ($50,000). This would result in a profit of $40,000.
The stock option grant agreement typically includes important details such as:
- Vesting Schedule. The vesting schedule specifies when an employee’s stock options become exercisable, or in other words, when they can be purchased by the employee. This is usually based on a certain amount of time worked at the company or achieving certain performance milestones.
- Exercise Price. The exercise price is the price at which an employee can purchase their shares when they decide to exercise their stock options. This price is usually set at the fair market value of the shares at the time of the grant. As the price of the stock increases, the options become more valuable.
- Expiration Date. The expiration date is the deadline by which employees must exercise their stock options before they expire. It’s important for employees to keep track of this date so that they don’t miss out on any potential gains from their equity compensation.
Exercising stock options can have tax implications for employees. When an employee exercises their options and buys shares at the strike price, they will be taxed on any gains made when they eventually sell those shares. It’s always wise for employees to consult with a financial advisor or tax professional before making any decisions about exercising their stock options.
How Stock Options Are Taxed
The IRS is concerned with taxing individuals on the receipt of property, which includes stock in our case. A stock option grants the recipient the right to buy stock at a certain price in the future, but the recipient does not receive the stock until they exercise the option. Therefore, according to the IRS’s definition, an income event does not occur on the grant date since the stock option holder does not receive any property.
In other words, stock options are not taxed when they are granted, but they are taxed when they are exercised.
Moreover, an 83(b) election is generally not required at exercise. Since most stock option recipients exercise their options in a “traditional exercise” after vesting, no 83(b) election would be made for the stock. However, if the company offers early exercise, where the optionee can exercise an unvested option and receive unvested stock, then an 83(b) election could be made in connection with that early exercise. If you’d like to learn more about 83(b) elections, click here.
Vesting schedules are an important part of stock options in startups. When an employee is granted stock options, they typically do not have full ownership of those options right away. Instead, the options vest over time according to a vesting schedule.
When it comes to structuring a vesting schedule for stock options, there are several factors to consider. Here are some key considerations:
One approach is to tie the vesting of restricted stock to individual or company milestones or performance targets. This can incentivize employees to work toward specific goals and help align their interests with those of the company.
However, the most common approach is time-based vesting, where options gradually become vested over a set period of time. This can be structured in different ways, such as monthly, quarterly or annually. Generally, stock options are granted with a four year vesting schedule and a one-year cliff, where the shares vest monthly.
Most vesting schedules have a cliff, which is a date when the first tranche of options vests. The most common cliff is one year. If the employee is on a one-year cliff, they will not vest any of their options until the one-year mark. On the 12-month anniversary, they will vest all 12 months. The purpose of the cliff is to give the company enough time to assess the employee’s performance. If the startup hires an employee and realizes that they are not a good fit within the first year, they can terminate without that employee walking away with shares in the company.
It’s important to note that there is no one-size-fits-all approach when it comes to structuring a vesting schedule for stock options. Companies should consider their unique circumstances and consult with legal and financial experts before implementing any equity compensation plan. If you’re looking for legal counsel, reach out to us here.
Types of Stock Options
When it comes to stock options in startups, there are two main types: incentive stock options (ISOs) and non-qualified stock options (NSOs).
Incentive Stock Options (ISOs)
ISOs are a type of stock option that can only be granted to U.S. employees. They offer certain tax advantages, as any gains made from exercising the options are treated as long-term capital gains rather than ordinary income.
To qualify for these tax advantages, there are certain requirements that must be met. For example, the employee must hold onto the shares for at least one year after exercising their options and at least two years after receiving the grant of the option.
Additionally, there are limits on how much ISOs can be granted to an employee in any given year.
Non-Qualified Stock Options (NSOs)
NSOs are a type of stock option that can be granted to both employees and non-employees such as consultants or contractors domestically and internationally. Unlike ISOs, NSOs do not offer any special tax advantages.
However, NSOs offer more flexibility when it comes to structuring the terms and conditions of the option grant.
It’s important for both companies and employees to carefully consider which type of stock option is best suited for their needs and goals. While ISOs offer certain tax advantages, they also come with more restrictions and limitations compared to NSOs. Ultimately, the right choice will depend on each company’s unique situation and goals.
Stock Option Liquidity
When it comes to stock options in startups, liquidity is an important consideration. Unlike publicly traded companies, where employees can easily buy and sell shares on public exchanges, private companies usually restrict the sale of their shares. This can make it difficult for employees to sell their stock options or shares, even if they are fully vested.
In some cases, private companies may allow secondary market sales, where employees can sell their shares to other investors. However, these markets can be illiquid and may not provide fair market value for the shares being sold. Additionally, there may be restrictions on who is allowed to participate in these markets, such as accredited investors only.
Risks of Equity Stock Options
While equity compensation can be an attractive form of compensation for employees, it’s important to be aware of the risks involved. One major risk is that the company’s value may not increase as expected. The sober reality is that some startup stocks become multi-billion dollar companies, but most fail. So, it’s very possible that your stock options may be worth $0 in the end.
As mentioned above, stock options have liquidity risk. Employees may not be able to sell their shares when they want to. In some cases, employees may need to hold onto their shares for an extended period of time before they are able to sell them, which could impact their financial planning and liquidity.
It’s also important to note that equity compensation can have tax implications for employees. As we discussed earlier, exercising stock options can trigger taxes on any gains made when selling those shares. So, if employees hold onto their shares for a long period of time and the value increases significantly, they may face higher capital gains taxes when they eventually sell those shares.
While equity compensation can be a valuable form of compensation for employees, it’s smart to work with a financial advisor or tax professional before making any decisions about exercising or selling stock options.