A Founder’s Guide to Employee Stock Options for Venture-Backed Companies

Employee stock options are a valuable tool for startups and high-growth companies to attract and retain top-tier talent. By granting employees the right to purchase company stock at the predetermined exercise price equal to fair market value, stock options align their interests with the company’s success and provide a powerful incentive for performance and loyalty.

What is a Stock Option?

At its core, a stock option is a contract that gives an individual the right to buy a specified number of company shares at a predetermined price, known as the strike price, within a fixed timeframe. This financial instrument provides employees with a unique opportunity to participate in the success of the company they work for.
When an employee receives stock options, it means they have the potential to become a company shareholder and share in the financial rewards of its growth.

This can be a powerful incentive for employees to work hard and contribute to the company’s success, as their efforts directly impact the value of the stock options they hold.

Stock options typically come with certain conditions that must be met before they can be exercised. These conditions often include a vesting period and certain performance or time-based milestones that must be achieved. The vesting period is the length of time an employee must wait before they can exercise their stock options. It is designed to encourage employee loyalty and ensure that they remain with the company for a certain period of time.

During the vesting period, employees may have the opportunity to earn additional stock options based on their performance or the company’s performance. This can serve as a motivating factor for employees to go above and beyond in their work, as it directly impacts their potential financial gain.

Once the vesting period is over and the conditions for exercising the stock options are met, employees can choose to buy the specified number of company shares at the strike price. The strike price is predetermined and is usually set at the IRC 409A Section fair market value of the company’s common shares. This allows employees to purchase the shares at a lower price when the company is in its early stages and potentially profit from any future increase in the company’s stock price as the company grows.

Understanding the details of stock options is crucial for both employers and employees to make informed decisions. Employers need to carefully design stock option plans that align with their company’s goals and values, while employees need to evaluate the potential risks and rewards associated with accepting stock options as part of their compensation package.

Overall, stock options can be a valuable tool for companies to attract and retain top talent, as well as motivate employees to contribute to the company’s success. By offering employees the opportunity to become shareholders, companies can create a sense of ownership and alignment between employees and the organization’s long-term objectives.

What is a Stock Option Plan?

A stock option plan, also known as an equity incentive plan, is a formal program that outlines the terms and conditions of granting stock options to employees. It serves as the foundation for defining who is eligible, how stock options are granted, and the rules governing their exercise.

The stock option plan lays out the types of vesting schedules the board may consider, the formula for determining the strike price (usually the IRC Section 409A fair market value), and any other relevant provisions. It is important for founders to work with experienced legal advisors to establish a clear and comprehensive stock option plan to ensure fairness, transparency, and compliance with legal and regulatory requirements.

What is an Option Pool?

An option pool refers to a block of shares “set aside” or reserved specifically for issuing stock options to employees. It is commonly created during the early stages of a startup to attract and retain top talent. By allocating a portion of the company’s equity to the option pool, founders can offer stock options without diluting existing shareholders’ ownership.

The size of the option pool is determined by various factors, including the company’s stage of growth, future hiring plans, and industry norms. It is crucial to strike a balance between maintaining sufficient equity for future hires and minimizing dilution to existing shareholders.

How are Stock Options Granted?

Stock options are typically granted by the board or directors to employees as part of their compensation package. The number of options granted is often based on factors such as the employee’s role, contribution to the company’s success, and market standards. Founders must carefully consider these factors to ensure that the option grants are fair and align with the company’s goals.

When granting stock options, companies should also consider various legal and tax implications, including the need for compliance with securities laws, tax laws, accounting standards, and regulations governing equity compensation.

What is the Strike Price of an Employee Stock Option?

The strike price, also known as the exercise price, is the price at which an employee can purchase company shares when exercising their stock options. The strike price is typically set at the fair market value of the company’s stock on the date of grant.

The strike price plays a crucial role in determining the potential value of stock options. If the market price of the company’s stock exceeds the strike price at the time of exercise, employees can generate a profit (which is taxable) by purchasing shares at a lower price and selling them at the higher market price.

What Determines the Strike Price of Stock Options?

Several factors influence the determination of the strike price for stock options. These factors include the company’s current valuation, future growth prospects, industry trends, competitive landscape, and other factors typically detailed in an IRC Section 409A fair market value report. To comply with tax law and avoid creating a taxable event for the recipients of stock stock options, the startup must set the strike at no less than the fair market value of the company’s common stock. However, because the company is usually in the early stages of its life, the 409A FMV is usually a value that offers meaningful potential upside for employees while still reflecting the company’s true value.

Additionally, when the strike price of stock options is set below the current market price, it may trigger certain tax implications for both the company and the employees. It is essential to consult with legal and tax advisors to navigate these complexities and ensure compliance with applicable laws.

What is a 409A Valuation?

A 409A valuation is a formal appraisal of a company’s common stock to determine its fair market value for the purpose of issuing stock options. This valuation is typically required by the Internal Revenue Service (IRS) to comply with tax regulations and avoid penalties.

Founders should engage a qualified independent 409A valuation services firm to perform a 409A valuation to ensure the accuracy and credibility of the company’s stock valuation. Failing to obtain a valid 409A valuation can result in severe tax consequences for both the company and its employees.

How Does the Value of a Stock Option Change Over Time?

The value of a stock option can fluctuate over time due to various factors, including changes in the company’s financial performance, market conditions, and investor sentiment. Stock options become more valuable as the company’s stock price increases above the strike price.

It is important for employees to track the performance of their stock options and consider market conditions when deciding whether and when to exercise their options. Founders may also be able to implement strategies to provide employees with periodic updates on the value of their options and educate them on the potential benefits of exercising at opportune times.

What Does Vesting Mean as it Relates to Stock Options?

Vesting refers to the gradual accrual of ownership rights to stock options or other forms of equity compensation based on predetermined conditions. These conditions are typically time-based and may also include performance milestones or a combination of both.

For example, a commonly used vesting schedule is four years with a one-year cliff. Typically, this indicates that the employee’s vesting commencement date is the date of employment but the employee must work for the company for one year before any stock options vest. In a vesting schedule that is four years with a one-year cliff, after one-year of continuous service, the employee vests in 25% of the stock options, and the remainder vests over the next three years (typically monthly).

Vesting is designed to incentivize employee loyalty and ensure that they remain committed to the company’s long-term success. It also gives the company an opportunity to evaluate employee performance and make any necessary adjustments in the equity compensation structure.

When do Stock Options Terminate?

Stock options typically have a defined expiration date, known as the expiration period, after which they become worthless. The expiration period is set when the stock options are granted and is usually up to 10 years from the date of grant.
It is important for employees to be aware of the expiration period and take appropriate action before their options expire. This may include exercising the options, or letting them expire if the strike price is higher than the current market price.

What Does it Mean to Exercise a Stock Option?

Exercising a stock option refers to the process of actually purchasing the company’s shares at the predetermined strike price set out in the stock option notice of grant. Once an employee exercises their options, they become a shareholder and may enjoy the associated rights and benefits, such as voting rights and potential dividends.

Exercising stock options often requires careful consideration of financial, tax, and investment implications. Employees should consult with financial, tax, and legal advisors to assess the potential risks and rewards before making decisions.

What are the Tax Implications of Exercising a Stock Option?

Exercising stock options can have significant tax consequences for both the company and the employees. The specific tax treatment depends on various factors, including the type of stock option, the length of time held, the exercise price, the fair market value at the time of exercise, and the applicable tax laws in the jurisdiction.

For incentive stock options (ISOs), taxes are usually deferred until the shares are sold. However, the alternative minimum tax (AMT) may still apply when ISOs are exercised. If certain holding period requirements are met, the gain upon selling the shares would be taxed as long-term capital gains. If the holding period requirements are not met, the excess of the fair market value of the shares over the exercise price is taxed as ordinary income.

For non-qualified stock options (NSOs), the difference between the fair market value of the shares and the exercise price is considered taxable compensation income when the options are exercised. This income is subject to ordinary income tax rates as well as payroll tax withholdings. When the shares are eventually sold, any gain or loss is taxed as a capital gain or loss.

Employees should watch out for a phantom income scenario when exercising options at a time when there is no liquidity event, yet there is a spread between the fair market value and the exercise price. This can result in an unpleasant tax bill on paper profits even before any shares are sold. Strategies like the Section 83(b) election and share vesting conditions can sometimes help mitigate this risk.

The company granting the options is usually allowed a tax deduction equal to the amount of ordinary income recognized by the employee. Complex rules may limit the company’s deductions in some cases. Accounting rules also require companies to take a compensation expense charge on their income statement when reporting earnings.

Given the intricate tax treatments and consequences, employees would benefit greatly from consulting tax professionals when making decisions about exercising stock options. In may be wise for companies to have thorough policies in place detailing the tax impacts and make counseling resources available for their employees navigating these decisions. Keeping communication open and clear around the tax and financial implications promotes good faith and avoids misunderstandings down the line.

Common Mistakes to Avoid When Issuing Stock Options

When it comes to issuing stock options, founders must be aware of common pitfalls and avoid making costly mistakes. Some of the key mistakes to avoid include:

  • Not having a well-designed stock option plan that aligns with the company’s goals and complies with legal and regulatory requirements.
  • Offering stock options without considering the potential dilution to existing shareholders and the impact on future fundraising efforts.
  • Setting a strike price that does not reflect the company’s true value or fails to provide meaningful potential upside for employees.
  • Failing to communicate clearly with employees about the terms, conditions, and potential risks associated with stock options.
  • Not providing employees with regular updates on the value of their stock options and the company’s progress.
  • Overcomplicating the stock option granting process, leading to confusion and administrative challenges.

By avoiding these common mistakes, founders can ensure that their stock option program is effective, transparent, and beneficial for both the company and its employees.

Employee stock options play a critical role in attracting, motivating, and retaining top talent in venture-backed companies. Founders must have a solid understanding of the key aspects of stock options, including their structure, grant process, taxation, and potential pitfalls.

By implementing a well-designed stock option plan and avoiding common mistakes, founders can leverage stock options as a powerful tool for driving growth and success in their companies.

How can Eton help?

At Eton Venture Services, we pride ourselves on delivering professional, comprehensive valuation and financial advisory services tailored to your unique needs. Don’t settle for generic software models or inexperienced teams when it comes to critical financial valuations for your business. Trust Eton’s expert team to provide thorough, data-driven assessments that empower you to make well-informed decisions and optimize your outcome. Join the industry leaders who have already benefited from Eton’s exceptional client service and advisory expertise. Let us guide you through the intricacies of startup incentive equity and vesting. Get in touch with Eton Venture Services today.

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President & CEO

Chris co-founded Eton Venture Services in 2010 to provide mission-critical valuations to venture-based companies. He works closely with each client’s leadership team, board of directors, internal / external counsel, and independent auditor to develop detailed financial models and create accurate, audit-proof valuations.

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