Startup Stock Options 101: Part 2 - How Do Stock Options Work?
Now that we understand the terminology from the explanation in Stock Options 101: Part 1 - Must Know Terminology, we can get to the good stuff: how do options work, when they can be granted, what are they worth and how can my company plan for them? How Do Options Work?
Before we get into talking about how you can plan your stock option strategy, let’s get to the basics of how they work. Stock options can be granted to employees, advisors or even vendors. Investors purchase their shares in the company and therefore do not need to be granted, however, accepting a new investor may need to be approved by your board.
If you are granting options to employees, you can have a new employee grant and or additional grants. For new employees, the option grant amount of shares will be indicated in the offer letter or contract. This is an agreement that promises that you will request that the board approves the options. You are not able to grant options without board approval. Also, you cannot guarantee the strike price of the promised options since the strike price is subject to change based on a number of factors.
Once the new employee starts you are then able to request that the board approves the option grant. The easiest way to do this is to keep a running list of the options you would like to grant and have them approved at the next board meeting. Alternatively, options can be granted by the board at impromptu board meetings. Since board meeting minutes must be recorded, you will have a record of the approval. This is important in the case that there has been ad administrative error on your side where the paperwork was not sent out or not completed properly, for example.
Granting additional options for current employees can happen at any time. Most companies use additional grants to incentivize employees who perform well. Also, granting additional options will reduce dilution to the employee’s ownership stake. Some companies will provide a written document indicating the intention to request board approval for an additional grant. Once promised, add that employee’s proposed grant to your running list.
Stock options can also be granted to advisors or even vendors. First you will send a document to the advisor or vendor with the amount of options that you have agreed to grant them upon board approval. Startup advisors will provide their knowledge, insight and experience for some options in your company. Vendors may accept options in lieu of or for a discount on on their services. Since all options will be approved together, once you have agreed with the advisor or vendor, add their info to your runny list of option grant approvals for the next board meeting.
Once options have been approved by the board, option grant paperwork has to be sent to the option holder for their signature as well as the signature of an authorized person at the company. If the option holder does not sign the grant paperwork, they risk a claim to their options. The biggest risk here is that a liquidation event takes place and the paperwork is not in order. It is possible that the employee does not actually receive the payout due to this paperwork issue.
Even though it is really hard to keep paperwork in order at a startup, it is also very important to keep these documents in order. Many startups let their law firm handle or rely on option software, like eShares. The day that you grant the options they may not be worth a lot and just seem like needless paperwork, but in the event that your company gets a great offer for an acquisition, they can be worth cash to people. Take the time to keep your option grant paperwork in order so that you do not regret it later. Verbally promised options, improperly prepared paperwork, missing documents or unsigned grants will only create problems for you.
Once the options have been granted and the option grants have been signed and accepted by the option holder, options can be exercised. Depending on your company’s stock option plan, option holders may be able to exercise options that have not yet vested.
In order to exercise options the option holder will need to fill out a form that you have provided in the stock option plan or via your stock option software to purchase the shares. There they will need to indicate the number of shares, strike price, social security number and the name that the options should be registered to. Here, the registrant could be the holder, the holder and their spouse or in trust.
Once options have been exercised, make sure to keep your records up to date. You should make sure that your accountant, bookkeeper, head of finance, etc knows how to record this in your books.
When Can Options Be Granted?
Options can only be granted when the valuation of the company is known. The valuation of the company is always known except during the following times:
- When a company is actively seeking investment. This could start when the executive team goes on a roadshow to look for investors for a round of funding, for example.
- If more than one year has elapsed since the last valuation from a third party valuation company. Or possibly more often depending on the stage of the company - later stage may require more than one valuation per year. Since the valuation of the company depends on financials and the business plan, the valuation must be reviewed from time to time to evaluate how the business is doing.
- Any other macro event that will directly affect the success of the business: significant change in interest rates or the economy does much better or worse than expected. This last reason affects more mature companies more often than young startups.
Options can be granted at scheduled or impromptu board meetings and regarding employees, they can only be granted to current employees. For example, if you have a board meeting today, you cannot grant options to employees who will start next week. The grant will have to wait until the next meeting.
If you have forgotten to grant options you cannot go back and grant options to that person at a previous strike price. Options can only be granted at the current fair market value. The only piece that you can play with here is the vesting start date.
How Much Are Options Really Worth?
Until there is a liquidation event, the options are worth the fair market value times the number of options. For example, you have 1,000 shares at a strike price of $1.00 and the current fair market value is $2.00, your 1,000 shares are worth $2,000. This is important today because if you were to exercise your options, you may have a tax liability on the $1,000 in capital gains.
But that isn’t really what being part of a VC backed startup is all about. From the entrepreneur’s point of view, you are building your vision and plan to either get acquired or do an IPO (in case you forgot that you have to pay back you investors), the value of your options is the range of what you could sell the company for today (current valuation) to what you think you could sell it for at its highest value.
Here you need to go through an exercise: what is the best possible exit scenario for your company? Calculate that number and figure out how much you would get paid out in that scenario. Remember that founders and other key employees will probably get golden handcuffs, meaning the payout will be staggered over time and usually after continuing to work for the company for a X years. But for estimate purposes, let’s imagine it is all cash and not based on continuing to work for the company after the acquisition.
How do you motivate employees around their equity compensation? Paint the picture of what you see as the future of the company and talk about similar exists. For example, a competitor recently sold for $100 million and you think your company has a good chance of an exit like that, let them know. After all, stock options for a startup are really about the vision of what can be built.
How Can I Plan To Grant Options At My Company?
Everything goes back to your financial plan so make sure you have a tight plan that was created by someone who knows what they are doing and is measured and revisited often. The consequences of a poor financial plan affect option grants for your employees. If you significantly under or overestimate your hiring plan, your employees will suffer the consequences: lower ownership stake, dilution, etc.
First, I want to remind you the purpose of granting options to employees. No, it is not because every other startup is doing it. It is align the risk and reward of employees and to encourage employees to work in terms of the success of the entire company.
There is a certain amount of risk joining a startup: it is not established in the market and there is a greater risk that things will not go well. Granting options to employees says "hey, I know that you could join GE [or fill in other Fortune 500] and be set for the next 10 years, but you believe in our vision. Here is a small piece of the company that you will earn over time with your hard work." Also, You want to make sure that employees are concerned with the company doing well as a whole, not just them or their department. This creates an environment where employees want to work together towards a common goal: success of the company. Keep this is mind when creating your option plan. Although from the finance point of view, we really like to apply numbers and formulas to everything, stock options are about the employees who are helping to build your vision. Take care of those people who are working hard for you.
Let’s assume that you have a solid financial plan. You know how many people you are planning to hire and for what roles and levels over the next 24 months. Don’t forget to include promotions and additional grants. Start by parsing out the types of roles and levels of the employees and analyze: how do each of these roles help to move your company along? Should the compensation be heavier on cash or equity? How much value does this role add to your company? Once you have an idea around this, you can start to weigh the equity compensation of each role comparatively to the others.
Now, open up excel and add each role to a row and then the number of people you are planning to hire for each of those roles. Start playing around with the amounts you would like to grant to those roles. Keeping in mind the total amount of the available pool, create a plan for each role and promotions. Don’t forget to set aside options for advisors.
To learn about what others are saying about options planning, you can check it out here and here. Remember, it is really up to the founders as to what you think is right and fair for your business. Understanding the process and what you can and cannot do is the basics, how you apply it will be up to you.