Typical employee stock options

ESOs are a form of equity compensation granted by companies to their employees and executives. Like a regular call option, an ESO gives the holder the right to purchase the underlying asset—the company's stock—at a specified price for a finite period of time.
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Founders find this best accomplished by sticking to an "everyone gets stock options" principle, so that the only negotiation is about how many shares are covered by the stock option grant and what the vesting schedule should be. An exception to the "stock options only" principle sometimes occurs during negotiations to attract and hire an experienced senior executive who may request restricted stock, but even then the benefits of an "everyone having the same" form of equity may prevail.

In this article, we provide an overview of some of the key considerations in making stock option grants: who gets an option, the size of the option, vesting terms and pricing. After the formation of a startup and prior to any significant financing, companies should and often do consider establishing a pool for providing equity grants to initial employees, consultants, advisors and directors. For example, if the founders hold 9 million shares, a pool of 1 million shares might be set aside for equity grants, including stock options, to be made between formation and the anticipated time of a first financing.

In this case, the pool would be 10 percent of the shares expected to be issued or granted under options and other equity awards prior to the financing. There is no magic to 10 percent; the number should be based upon what the founders think they need in their particular situation. However, as a practical matter, some amount between 5 percent and 20 percent would be typical. See our article with more considerations about sizing an option pool. A new pool is often created as part of the negotiation for the first substantial financing, typically to provide for enough shares to cover the estimated number of option grants between the first and the second financing.

How Employee Stock Options Work In Startup Companies

A typical pool following a Series A financing would be of around 15 percent of the number of post-financing shares outstanding or reserved. Of course, the shares of stock for the pool and for stock option grants should be for common stock, as there are tax rules that make it very difficult to grant stock options for preferred shares or stock that has distribution preferences.

Prior to the first financing, it is common to have consultants, advisors, board members and non-officer employees receive option grants of. Bond investing risks. Mutual funds Investing in mutual funds. How to pick mutual funds. Asset allocation Asset allocation. Hiring financial help Hiring financial help. How to hire a financial planner. Buying a home Buying a home. Selling a home Selling a home.

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Size of the option pool

This means that after working for a company for a full year, the employee will receive the first quarter of their shares 1 year cliff. After the first year, the employee will receive their remaining shares over the next 3 years on a specific calendar. There are clear pros and cons of employee stock options.


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Generally speaking the benefits of ESOs outweigh the cons. From the perspective of a startup, the benefits of ESOs are quite clear. Generally speaking startups are strapped for cash and may not be able to compete with larger firms hiring for the same positions. When top talent is evaluating where to work they are generally looking for a few things: ownership, collaboration, transparency, and growth.

Ownership can come in 2 forms, ownership in their work and ownership in the company. Offering ownership in the form of stock options is a surefire way for a startup to find and retain top talent. At the end of the day, early startup employees are taking a risk and likely a paycut to join a team that is attacking an interesting market or building a strong product. Rewarding talent for taking the risk is a must for early stage startups.

As we alluded to above, the pros of offering employee stock options are quite clear for a startup. On top of the ability they can be used as a tool to attract and retain top talent there are a few other pros:.


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However, with pros comes cons. While not as plentiful as the pros of offering employee stock options there still are cons of offering ESOs. As we mentioned above, there are still cons when it comes to startups offering employee stock options. A few common cons startups often see with employee stock options are:. While the pros generally outweigh the cons of offering employee stock options. There still are cons that startups and founders need to work through when it comes to offering stock options as a form of employee compensation at their company.

What Is a Stock Option?

Deciding when and how to issue employee stock options can be a difficult task. A startup or founder needs to understand how much they should pay employees in cash and then add in stock options. When setting out to issue stock options it probably looks something like this:.

As we mentioned above the tax benefits, or lack thereof, are an integral part of employee stock options. To recap here, the main difference comes between incentive stock options and non-qualified stock options. On one hand, we have incentive stock options. ISOs offer many tax benefits. ISOs are only taxed when selling the shares of stocks — and only taxed at the capital gains rate which is generally less than ordinary income tax.

On the other hand, we have non-qualified stock options. While more common, NSOs do not offer the same tax benefits as incentive stock options. NSOs are taxed both when exercising and selling. But what happens when ESOs are actually exercised? As we mentioned above, an employee usually does not have the ability to exercise their stock options until they have vested. For this example, we will say this is on a standard vesting schedule so they are allowed to exercise their options after the 1 year cliff.

So what happens after year 1 when an employee is allowed to exercise their options? Depending on your company, there may be a few different options when it comes to exercising your stocks. Two common options for exercising stock options you might see:. Pay cash — use your own cash to pay for the shares yourself. This is the highway risk approach as you are not guaranteed to make any profit on your share moving forward.

Employee Stock Options Guide for Startups |

Cashless — on the other hand you can use a cashless approach. This means one of two things. You can either sell enough of your shares to cover the purchase price of your shares. Or you can sell all of your shares in a single move. Vesting — The process used to reward shares and stocks to employees.

Generally this takes place over a period of time so shares are gradually rewarded. A common schedule for startups takes place over 4 years with a cliff after year 1. Vesting allows startups to retain employees by slowly rewarding shares. Incentivized Stock Options — One common form of employee stock options. Incentivized Stock Options are more preferable for tax purposes. Generally, someone only pays capital gain taxes when selling their shares. Non-qualified Stock Options — The other common stock option is non-qualified stock options.