Startup Stock Options: A Simple Guide for Founders and Employees
Maybe you’re a founder at an early-stage company, or maybe you’re a prospective employee comparing compensation packages before settling on the startup of your dreams. In either case, you’re likely here because you want to know more about how startup stock options work—how they’re granted, what types you may be eligible to receive, and whether they’ll end up being worth millions or nothing (or, you know, somewhere in between).
If you already know how employee stock options work in general, you’re off to a great start. Employee stock options at a startup don’t differ all that much in their basic mechanics from employee stock options at a later-stage company. With that said, there are some extra considerations related to startup equity that you’ll want to keep in mind.
In this guide, we’ll review the basics of employee stock options from the perspective of an early-stage startup employee or founder. That means we’ll spend a little more time breaking down things like how a startup determines the value of common shares when granting options, and how to think about options when an IPO or other liquidity event may still be a ways away.
- What are startup stock options?
- What are the different types of startup stock options?
- What should I look out for in a startup stock option agreement?
- What happens to my options if the startup I work for goes public?
- Next steps in understanding startup equity
What are startup stock options?
When people talk about stock options, they’re probably talking about either exchange-traded stock options or employee stock options:
- Exchange-traded options are a type of financial instrument that investors can buy and sell on a stock exchange. They are not stocks. Rather, they are contracts that allow, but do not obligate, investors to buy or sell shares of a certain stock at a certain price and date. You don’t need to be an employee of a company to buy or sell options contracts that derive their value from that company’s stock. And since early-stage startups are likely not publicly traded companies, it’s unlikely that options contracts related to their stock will be available on a public exchange.
- Employee stock options are a type of equity compensation that gives an employee the right, but not the obligation, to buy a number of shares of company stock at a specific price. If a company is still in its early stages, it’s possible that the only people who own equity in that company are employees, founders, and early investors. So, employee stock options are by definition not the kind you’d find investors trading on a public exchange.
When people talk about “startup stock options,” they are referring to Option Number 2, i.e. employee stock options granted to employees at a startup.
Employee stock options are, in fact, a popular form of startup equity compensation that you’ll likely encounter if you spend any amount of time in Silicon Valley. But not all employee stock options are made equal! Different startups may offer different types of options to different employees.
What are the different types of startup stock options?
Now that we’ve narrowed our focus down to employee stock options, let’s look at two common types of stock options granted to employees at early-stage startups. These are incentive stock options (ISOs) and non-qualified stock options (NSOs).
We have a whole guide that spells out the salient differences between ISOs and NSOs, but here’s a very simple overview of how they differ:
- ISOs can only be granted to employees, and they qualify for preferential tax treatment if they meet certain criteria.
- NSOs don’t have the same restrictions as ISOs, but they also aren’t subject to the same favorable tax treatment and are taxed at the ordinary income tax rate when exercised.
There’s a lot more to chew on than that, so really—check out our guide!
Aside from ISOs and NSOs, a startup’s cap table may include types of equity that aren’t stock options at all. These include common stock, preferred stock, restricted stock awards (RSAs), and restricted stock units (RSUs).
Aside from stock options, RSUs are probably the equity type you’re most likely to encounter as a startup employee. Rather than giving you the option to purchase stock at a certain price and date, RSUs simply convert into common stock when certain conditions (e.g. time restrictions and a liquidity event) are met. RSUs have a different tax treatment than stock options and they’re generally more common at later-stage startups and public companies. You can read more about why this is the case in our guide to RSUs vs. stock options.
What should I look out for in a startup stock option agreement?
Stock option agreements, also called option grants, can be an important part of the startup hiring process. A startup stock option agreement is just what it sounds like—an agreement between a startup and an employee that outlines everything the employee should know about how and when they’ll be granted options.
Your stock option agreement is not the same as your offer letter. Yes, your offer letter might include some information about how many options are included in your compensation, but the option grant is a separate document that you should carefully review and sign before starting your employment. Without a signature on the option grant, you aren’t technically entitled to your options.
Heads up: The option agreement is usually signed at some point after the offer letter, and there may be a brief delay between when you receive the offer letter and when you receive the grant.
Here are some of the key points to look for when you do receive your stock option agreement.
Total shares granted
Your option grant should clearly specify the total number of company shares you will be entitled to purchase with your options. Remember: this is not the number of shares you will receive outright, but rather the number of shares you can buy if you decide to exercise your options.
Type of options granted
Your grant should also specify the type of options granted. Many early-stage startups reward employees with ISOs or NSOs, so it’s helpful to know how these differ—especially in terms of their tax implications.
Exercise price per share
Otherwise known as the “strike price,” the exercise price determines what you’ll pay for each share if and when you exercise your options.
This exercise price is determined by the fair market value (FMV) of your company’s stock at the time of your option grant. Startups and other private companies must complete a 409A valuation—an independent, unbiased appraisal of how much their common stock is worth—before offering equity to employees. The 409A valuation determines the FMV of the company’s stock at a given time, and the FMV in turn determines the exercise price of stock options offered to employees.
Option grant date
This date determines when the agreement goes into effect.
Option expiration date
This date determines when your stock options will expire. (Yes! Stock options do expire!)
Keep this date in mind, as stock options retain no value beyond their expiration date. You can choose to exercise your options at the agreed-upon exercise price up to this date, but beyond it, those same options are worthless.
The date vesting starts
This date determines when your stock options begin to vest.
It’s important to understand how vesting works, because many companies offer equity contingent on some sort of vesting schedule. This means that you won’t receive all of your options or shares upfront; instead, you’ll have to wait a certain period of time or hit certain benchmarks specified in the option grant.
Many grants include language about a one-year vesting period, or “vesting cliff.” This means that your options will only begin to vest after you’ve stayed at the company for a full year. After the cliff, your options may vest on a more regular schedule.
A vesting schedule of four years is common among startups, but don’t assume anything until and unless it’s spelled out in your grant.
What happens to my options if the startup I work for goes public?
There are multiple different ways a startup can go public. It can raise money in an initial public offering (IPO), it can go public via direct listing, or it could even go public via a special purpose acquisition company (SPAC).
All of these are examples of an exit strategy or liquidity event, i.e. an opportunity for early investors and shareholders to convert their illiquid shares into actual dollars. In a liquidity event that takes your company public, your company’s shares will end up being traded on the public market. This means that your options will now have a value that’s tied to the underlying price of the stock now trading on the market.
The difference between your strike price and the current price of the stock sets the value for your options. If the former is lower than the latter, your options have some value. If the opposite is true and your strike price is lower than the current price of the stock, your options don’t have value and it likely doesn’t make sense to exercise them.
There are a lot of factors, including tax treatment, that can determine if and when you exercise your options after your company goes public. Because these factors can get pretty complex and involve individual circumstances, we recommend reaching out to a tax advisor or financial advisor for help.
What happens to my options if the startup I work for never goes public?
If the startup you work for never goes public, your choices may be more limited. But that doesn’t necessarily mean that your options have no value. Other types of liquidity events include direct acquisitions by another company or by a private equity firm.
These events may offer opportunities for you to cash out your options, or your options may be substituted with an equity award from the new company. Not every case is handled in the same way, and your options may be treated differently in an acquisition depending on whether they’re vested or unvested. Always be sure you know exactly what will happen to your options before deciding on a path forward.
Next steps in understanding startup equity
Options are a cornerstone of many startup compensation packages, and in many cases they can represent a major incentive to choose one startup over another. With that said, there are no sure things in this world. Keep in mind that for every successful startup to go public, there are a handful of others whose equity may not end up being worth all that much.
If you have more questions about stock options and other types of equity, Pulley is here to help. Schedule a call with us today, or read through some of our tactical guides for cap table and equity management.