How do employee stock options work in startups?
A company gets the suppleness through Stock Option Plans to award stock options to employees, officers, directors, advisors, and consultants. These stock options allow the employees to buy stock in the company when exercising the option. Stock Option Plans are a prevalent method of attracting, motivating, and hiring employees, particularly when the company cannot afford to pay high salaries. The success of the company is shared with the employees with the help of stock option plans. They can be a part of their company’s stock without having a startup business to spend their precious cash on.
Employees are allowed to share in the success of the company through stock option plans without needing a startup business to spend precious cash. As a matter of fact, Stock Option Plans also contribute capital to a firm as employees give the exercise price for their options. Stock Option Plans for a company can dilute other shareholders’ equity when the employees exercise the stock options. This could be one of the basic disadvantages of the stock option plans.
Considering the employees, the main disadvantage of stock options for them in a private company compared to cash bonuses or more significant compensation is the lack of liquidity. Till the moment a company develops a public market for its stock, the options will not be the equivalent of cash benefits. And, in case the company does not grow more prominent and its stock does not become more valuable, the options may prove worthless.
Thousands of people have become millionaires with the usage of stock options. This makes these options very appealing to employees. A great example of this is the spectacular success of Silicon Valley companies. The economic boost of employees as a result of holding stock options have put together Stock Option Plans as a powerful motivational tool for employees to work for the company’s long-term success.
After reading all the success the Employee stock option has to offer, the question arises, “How can a startup consolidate employee stock options in their company”?
Companies offer stock as part of their compensation package to share in the company’s success. But they don’t usually elucidate what you need to know in order to make informed decisions. Here’s how to make sense of the given offer letter and option grant.
How do the employee stock options actually work?
Both startup founders and early employees need to understand how employee stock options work. They must know various tax structures, terminology, and legal documents, making it an intimidating task. Nowadays, as stock options are an integral part of startup culture, everyone should be familiar with a few terms and ideas.
Granting
Generally, when signing a job offer, an employee will receive an offer grant. This is the moment when a company is offering or granting the option to buy stocks. It is vital to remember that stock options are not actual shares of stock but rather the option to purchase these shares at a set price later. So now the question arises is how do you make money on stock options? When the fee between the offer or the grant price and the company’s market value rises. This is when an employee can make money.
When an employee receives an offer letter, an employee will also receive a stock option agreement. This is a document that will include different dates, terms, and details that are pertinent to your grant. The document also covers:
- The type of options you will receive.
- The number of shares.
- The vesting schedule.
- The date of expiration.
Vesting
Vesting is used by companies and often referred to as a mechanism to make employees stay longer in their company. By definition, Vesting is a legal term to give or earn a right to a present or future payment, asset, or benefit. It is most commonly applied in reference to a retirement plan benefit. An employee collects nonforfeitable rights over employer-provided stock incentives or employer offerings made to the employee’s retirement plan account or to the pension plan.
As stated earlier, the moment you receive a stock option, it is not actual shares but rather the ability to buy shares later. To retain their employees, many companies will include a vesting schedule with their offer. It is one such schedule that will have the ability to exercise your shares. A vesting schedule generally takes place over a certain period of time and maybe split over a few years or milestones.
The most common vesting schedule for startups is a time-based schedule. A time-based schedule means that you will receive a set amount of shares over a set amount of time. Typically, a “cliff” or a set date in simpler terms is where you get the first portion of your shares.
The most common startup setup is a four-year vesting schedule with a 1-year cliff. This suggests that after working for an entire year, the employee will receive the first quarter of their shares (1-year cliff). Next, the employee will get their remaining shares over the next three years on a specific calendar, usually 1/36 of each month’s remaining shares.
You will better understand the entire process with the help of an example. The following example depicts how stock options are granted and exercised.
ABC Inc., hires an employee named Raj Smith. As part of his employment package, the company grants Raj options to gain 40,000 shares of ABC’s common stock at the rate of 25 cents per share which is the fair market value of shares of ABC common stock during the time of grant.
The options are subject to four-year vesting with one-year cliff vesting, which means that Raj has to stay as an employee of ABC for one year before he takes a right to exercise 10,000 of the options. After that he vests the left over 30,000 options at the rate of 1/36 a month for next 36 months of employment.
In any case, if Mr. Smith leaves ABC or gets fired before the end of his first year, he will not receive any of the options. After his options are “vested,” that is they become exercisable, he can buy the stock at 25 cents per share, despite that the share value has gone up dramatically.
In case he has continued to work for ABC, all 40,000 of his option shares are vested after four years. ABC becomes successful and goes public. Its stock trades at $20 per share. Raj exercises his options and buys 40,000 shares for $10,000 (40,000 x 25 cents). Mr. Raj sells all 40,000 shares for $800,000 (40,000 x the $20 per share publicly traded price), and hence, make a nice profit of $790,000.
Therefore, Employees with ESOPs, shift into potential shareholders of the company. As per the stipulated time frame defined in their ESOP contract, employees can buy the shares that were once given to them as an option. After this, they can either monetize all or some of these shares when a firm announces a liquidity event. A liquidity event such as buyback or secondary sale or an IPO (Initial Public Offering). The complete or partial monetization of ESOPs, if the startup has done well and has many valuations, will far exceed the standard remuneration of the employee. ESOPs in startups that are not exercised will terminate after a designated time frame and return to the ESOP pool. In much simplified terms, ESOPs authorize employees with a monetary edge.
This is how the Employee stock option benefits the employees. You can be a millionaire serving the same company honestly and provided that the company grows. A large number of people just joined a successful or growing company with Employee stock options and got their dreams of being a millionaire. Even many startups who do not have enough funds grow and thrive in the market this way.
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