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How Do Employee Stock Options Work At Startups

Stock options, startup, shares, finance, investment, compensation, salary.

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Oyemaja; How Do Employee Stock Options Work At Startups

The logic behind the employee stock options is that since the early employees are primarily responsible for the success of the company, they should own a part of it.

It incentivizes them to work hard for the growth of the company, since they have a stake in it. In the same vein, it compensates them for choosing to work for the startup, pooling in their skills for its success, as opposed to probably working at a bigger company with much more benefits.

First off, what are Stock Options?

Stock options are a form of equity compensation that gives an employee a right in the future to buy the startup’s stock at a pre-set purchase price. Regardless of the growth in the value of the stock over the years - if the company becomes valuable - the employee has the option to buy those stocks at the earlier agreed price.

For example, Flutterwave Tech Inc. kicked off in 2017 and offered stock options to its employee, James, at 1 Naira per 1 ordinary share. In 2023, since Flutterwave has been successful, their stock has risen to 20 Naira per 1 ordinary share. James will be able to exercise his employee stock option by buying the number of stock given to him at the price of 1 Naira per 1 ordinary share in 2023, instead of 20 Naira which is the price the public buys for. Thus, James is able to make a profit off the difference if the stock value goes up.

Essential to note is that stock options are not a guarantee of financial gain. if the company fails and isn’t valuable, then the employee gains nothing.

Why Do Startups Use Stock Options?

Essentially, It is a win-win for the employee and the startup.

Startups are looking for the best people to join their teams, but many times, cannot pay the standard price to acquire them. Where they are able to convince people to join their team, stock options are a means of rewarding them. Thus, for their hard work and for betting on the company’s success, they get a piece of the company when it becomes valuable and are able to sell that for financial gain. The company gets amazing people to build its product, the people gain sizable financial gain in return. Win-win.

Also, stock options are a way of bringing in people who believe in the future and vision of the company enough to play the long game and work hard to ensure the success of the company. The options are terminated when an employee leaves the company before they vest and vesting periods usually last a long period of time. Thus, keeping the best people around to build your product.

This is also a way of retaining employees.

What Type Of Stock Options May One Get?

The two most common types are the Incentive stock options (ISO) and Non-qualified stock options (NSO).

  1. Incentive Stock Options (ISO): These are given to key employees as a form of compensation. The catch here is that the profits made from the exercise of this stock option is not subject to tax. ISO’s are usually the go-to for startups because it allows them offer potential gains to their employees, without them paying taxes.

  2. Non-qualified stock options: These are given to employees across board and are taxable. This is because the profits on these are considered income, thus they are taxed as such. Nonetheless, there is still a guarantee of making profits here if the stock price of the company goes up.

There are other types of stock options; Restricted Stock Grants, Stock Appreciation rights, Phantom Stocks, granted in more mature companies. However, for startups which our topic borders on, ISO’s and NSO’s are the major ones to focus on.

Important Concepts To Note

These may come up in the stock options agreement and to fully understand what you are getting into, it’s best to understand these concepts.

Vesting: To vest a stock option is to exercise your right to buy that stock option.

Cliff: This is the period of time an employee has to wait before the options start to vest, after which they do so on a vesting schedule. Think of it as probation. The cliff period usually lasts one year at most startups.

An example of how this works is: Flutterwave in 2017 may give James $1000 stock options with a cliff period of 12 months and a vesting schedule of 4 years. So James cannot exercise any of the allocated $1000 stock options until the end of 12 months.

This makes sense because some people leave companies before their first year is up. Without the cliff, an employee would leave the company in say 5 months and take a piece of the company with them.

Vesting schedule: This is the time it takes for an option to fully mature i.e. vest.

For example; the 4 years vesting schedule in our Flutterwave example above. The schedule may provide that the employee gets 25% of the stock options for every year within that 4 year vesting schedule. By the end of the 4 years, they get 100% of their stock options and gain their full financial reward from working with the company, once they exercise the option.

So if James decides to leave Flutterwave in his 3rd year, he gets 50% of $1000 in stock options, which is $500.

Option Schemes: These may be exit-only or exercisable. Using our Flutterwave example to explain these terms; if the option scheme given to James was exit-only, he cannot exercise any part of the options given to him until an “exit event.”

What is an exit event? These may include the sale of the company, merger with another company, a management buyout or a change in control of the company.

However, if the option given to James was exercisable, then he can exercise some of the options given to him before the vesting schedule is complete.

The Stock Options Life-Cycle

The Founder decides on the number of stock options to grant: This is the first step. The founder decides the amount of his startup he is willing to part with and grants such to the employees. Some top hires may negotiate the grant and the vesting schedule, but that is dependent on the discussion between parties.

The Employee signs the Stock Options Agreement: These are legal agreements that usually provide the rights of the employee and employer on the stock options. They also provide for the following:

  1. The number of shares granted

  2. Type of options

  3. Grant date

  4. Cliff period

  5. Vesting schedule

  6. Termination period

  7. Exercise of option

  8. And such other terms as is expedient.

The Employee exercises their options: When the vesting schedule is complete and the options of the employee are mature, they may choose to exercise their option. To exercise means to purchase the stock at the pre-set price given to the employee, regardless of the current price of those stocks.

What Happens If An Employee Leaves?

The stock options will immediately stop vesting. However, depending on the option scheme, the employee may be able to exercise the portion of options that has vested before the termination of their employment.

It is important to note that these options do not exist in perpetuity as you may maintain those options for a set time (usually 3 months) after termination.

When Is the Right Time To Set Up Employee Stock Options?

Usually at the early stages of your startup. This is because having stock options serves as an incentive to attract the best people to work with and retain them for a long term.

Important To Note: The foregoing is not legal advice and it is still essential to contract a lawyer to aid in setting up your stock options plan or to review your stock options agreement when given by a company.

In conclusion

Stock options are an amazing way to gain the best hands, while rewarding them for their belief in the vision of the company. It is a great option for startups without a lot of capital to attract experienced hires and for employees who are keen on developing great products that would be invaluable to the growth of society in the long run.

Originally published by Victoria Akingbemila (AICMC) on Linkedin

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