Startup Stock Options 101: What to Know
Creating a startup company is a massive challenge, but exploring the world of stock options brings a whole new level of confusion.
Many startup founders aren’t experts in finance. So, if you’re trying to work out whether assigning startup stocks is the right choice for employees of your company, the chances are you’re scratching your head pretty hard.
If you’re considering offering stock options to your startup employees, we’re here to help you learn about the decision and what exactly it involves. Here are the startup stock options 101!
How Do Startup Stock Options Work?
If you’re a startup founder, then the classic stock option is to offer shares of stock at a specific price. For example, if you sell for a penny each, you’ll be able to invest that money into your company. If those shares become worth more than the penny, the employee or investor will make money from it once it’s sold.
But, it’s important not to offer too many stock options, as this can affect the capital structure of your company. If many employees are getting compensated with their professional work from stock options, then investors may be less likely to find the stock valuable.
Figuring out startup company stock options is an area you may want to discuss with a financial advisor. This is so you can decide what percentage of your stock you’d like to distribute between investors, employees, and advisors.
When it comes to offering stock options, companies can offer these equity options to the first employee until they decide not to anymore. Many startups decide to offer stock options until they can afford to pay employees a market salary, and then stop offering stock options in the future. Others continue to offer stock options as part of an ongoing incentive package.
The first option means you can avoid diluting the company’s stock, while the other offers the advantage of retaining quality staff and offering employees a sense of ownership in the brand.
It depends on the founders’ preferences on the best route to take.
What Are the Advantages of Startup Stock Options?
So, you may be wondering, why add the headache of figuring out and distributing startup stock options? Here are the main reasons why it’s worth it.
Stocks Can Make up a Gap Between Salary and Market Rate
Startup companies are often very exciting for new employees to join and offer them a lot of benefits. Employees can work with a company offering fresh and exciting ideas, and there may be a lot more flexibility in working hours.
Plus, many startup companies offer fun incentives such as ‘beer and pizza Fridays’ or complementary yoga classes. Doesn’t sound half bad, does it?
Yet one thing many startup companies can’t offer is a competitive salary that meets the market rate. In the corporate world, a job in a similar field may offer a much higher pay package.
But the offering of startup stock options to employees can help save the day, bridging the gap between their salary and the standard market rate.
Stocks Help Retain Employees
This leads us on to the difficulty many startups have on retaining employees. As talented employees can make a fair amount more money elsewhere, it’s often hard to keep quality workers.
Employees are offered startup stocks in a vesting provision. This means that they must stay with the company for several years before they’re entitled to the full equity. Generally, this gap is usually covered for around two or three years, but it varies depending on the company.
This means that offering startup equity stock options is a great way to keep quality candidates for the company. This is especially important during those first difficult years, where rough patches are most likely to occur.
It’s also a positive message to send out to founders and employees. If you work with the company and stick around, if big money is made in the company, those investing in the company can make money too.
Likewise, having stocks within a startup company can motivate employees. Invested employees are in part ownership of the company, so they’re more likely to work harder so the startup becomes successful in the future.
As with anything, people feel a greater sense of pride and investment when working on anything they own themselves. This is why startup stock options create a positive and hardworking company ethos and workforce that is also viewed favorably by outside investors, too.
How Much Are Startup Stock Options?
Stock options are attractive to employees as there isn’t much risk when it comes to investment, yet there’s plenty to gain. For example, if an employee receives a stock option when the strike price is $1 and the price rises to $10, they reap the $9 gain.
But, if the price lowers to below $1, the employee can choose not to buy the underlying share and loses nothing.
What Are the Legalities Behind Startup Stock Options?
As stock options have been abused for years, there are lots of legal restrictions when it comes to distributing startup stock options. For example, many companies have used stock options to pay workers in a way that results in getting taxed as capital gains instead of regular income. As you’ve guessed, this is at a much lower rate.
This means that the government watches the behavior surrounding startup stock options and issuing stock options involves a fair amount of legal work.
Those offered stock options in a startup will also have tax choices to make. For example, if the individual purchases the options quickly, they’ll hold onto them for longer and will pay long-term capital gains taxes when they cash in, which are lower.
But if they don’t buy them straight away and the company never gets to an exit, then they can save some cash.
While there are many advantages to offering startup stock options, the main disadvantage is that understanding and distributing them is complicated. Many employees struggle to completely understand the process. Yet today, many startups educate new hires on startup stock options and offer training sessions to existing employees. This is why it might be useful for a company to hire a collaborator specialized in these startup stock options.
If you’re interested in distributing startup stock options, it’s recommended to hire a financial advisor for an hour or two at the very least to make sure the process all runs smoothly.