What are employee stock options (ESOs)?
Employee stock options are vital for all startup founders and employees to understand. For startup employees the benefits often come in other forms than salary — one of the major ones being ownership in the company.
Discussing stock options and compensation plans can be intimidating — especially for first time founders or employees working at a startup for the first time. New terms are thrown and legal documents are thrown around in conversation which can lead to confusion and intimidation. However, this does not need to be the case. The guide below is intended to help both startup founders and employees understand the basics on employee stock options.
Investopedia defines employee stock options as, “a type of equity compensation granted by companies to their employees and executives. Rather than granting shares of stock directly, the company gives derivative options on the stock instead. These options come in the form of regular call options and give the employee the right to buy the company’s stock at a specified price for a finite period of time. Terms of ESOs will be fully spelled out for an employee in an employee stock options agreement.”
The benefit of ESOs for early employees is quite simple. By choosing to work for a startup an employee is taking an inherent risk. To get compensated for the risk employees are offered ESOs. If the startup’s stock price rises above the exercise price, an owner of stock options will make out well.
On the flip side, startups are also incentivized to offer employee stock options. By offering stock options founders and startups are incentivizing employees to work towards growing the company’s valuation and also encourages an employee to stay with the company as they have to wait for the stocks to vest (more on that later).
Ultimately, employee stock options are an instrumental part of finding and retaining top talent for startups. While strapped for cash, startups often cannot compete with salary offers from larger firms so can attract top talent by offering equity and ownership in the company.
Is an Employee Stock Ownership Plan (ESOP) the Same Thing?
Similar but not to be confused with employee stock option plans are employee stock ownership plans. As defined by the SEC, “An employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock (or money to buy its stock) to the plan for the benefit of the company’s employees. The plan maintains an account for each employee participating in the plan. Shares of stock vest over time before an employee is entitled to them. With an ESOP, you never buy or hold the stock directly while still employed with the company. If an employee is terminated, retires, becomes disabled or dies, the plan will distribute the shares of stock in the employee’s account.”
The key difference between an employee stock ownership plan and employee stock option is that an ESOP is a retirement plan. Whereas an ESO is when an employee has the right to buy shares at a set price over a given period of time.
Related Resource: How to Choose the Right Law Firm for Your Startup
Are there different types of employee stock options?
Employee stock options come in two main types of options: incentive stock options and non-qualified stock options. The main difference between the two mostly revolves around their tax structure. There is a third type rarely used called “restricted stock units.” For the sake of this post we will be focusing on incentive stock options and non-qualified stock options.
Incentive Stock Options (ISOs)
As defined by Investopedia, “an incentive stock option (ISO) is a company benefit that gives an employee the right to buy stock shares at a discounted price with the added allure of a tax break on the profit. The profit on incentive stock options is taxed at the capital gains rate, not the higher rate for ordinary income.” Let’s break that down.
To get started, there are a few tax benefits when it comes to ISO. The first benefit comes when exercising (AKA buying) your shares. Generally speaking, you do not have to pay taxes when buying incentive stock options.
Assuming you exercise your shares and hold on to them for at least one year, you qualify for a tax benefit on the selling end as well. As Investopedia mentions above, when selling your ISO shares you are potentially taxed at capital gains as opposed to ordinary income. Generally speaking capital gains taxes are less than ordinary income taxes. This means that you’ll be taxed at the lower bracket.
However, if you sell your shares immediately after exercising you will be taxes at the ordinary income level (similar to Non-qualified stock options). ISOs are generally awarded to high level managers and high value employees. For a startup, this usually means the early employees and founders.
Non-Qualified Stock Options (NSOs)
On the opposite end of incentive stock options are non-qualified stock options. As defined by Investopedia, “a non-qualified stock option (NSO) is a type of employee stock option wherein you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.” So how do NSOs differ from ISOs? As we mentioned earlier, it comes down to the tax benefits.
Whereas incentive stock options are only taxed when selling (and potentially taxed at the capital gains rate), non-qualified stock options are taxed when exercising and selling your shares. Non-qualified stock options are more common than incentive stock options.
Related Resource: The Main Difference Between ISOs and NSOs
How Do Employee Stock Options Work?
It is important for both startup founders and early employees it is important to understand how employee stock options work. The different tax structures, terminology, and legal documents can make it an intimidating task. As stock options are an integral part of startup culture there are a few terms and ideas that everyone should be familiar discussing.
Granting
Generally when signing a job offer you will receive an offer grant. This is when the company is offering/”granting” the option to buy stocks. It is important to remember that stock options are not actual shares of stock but rather the option to buy these shares at a set price on a later date. So how do you make money on stock options? When the price between the offer or grant price (the price you can buy the shares at) and the market value of the company rises.
At the time of receiving an offer letter you will also receive a stock option agreement. This document will include different dates, terms, and details that are pertinent to your grant. This includes what type of options you will receive, number of shares, vesting schedule, and the expiration date.
Vesting
Vesting is a mechanism that companies can use to encourage employees to stay longer. As defined by Investopedia, “Vesting is a legal term that means to give or earn a right to a present or future payment, asset, or benefit. It is most commonly used in reference to retirement plan benefits when an employee accrues nonforfeitable rights over employer-provided stock incentives or employer contributions made to the employee’s qualified retirement plan account or pension plan.”
As we mentioned earlier when you receive a stock option this is not actual shares but rather the ability to buy shares at a later date. In order to retain employees, most companies will include a vesting schedule with their offer. This is the schedule in which you will have the ability to exercise your shares. A vesting schedule usually takes place over a period of time and may be split over the course of a few years or milestones.
The most common vesting schedule for startups is a time-based schedule. This means that you’ll receive a set amount of shares over a set amount of time. Usually there is a “cliff” which is a set date where you get the first portion of your shares.
The most common startup setup is a 4 year vesting schedule with a 1 year cliff. 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. Usually 1/36 of the remaining shares each month.
What Are the Benefits of Employee Stock Options?
There are clear pros and cons of employee stock options. 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.
Pros
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:
- Employee stock options give employees ownership in the company. This leads them to feel more invested in the success of the business.
- ESOs offers startups financial benefits. Instead of paying a large salary they can make more competitive and attractive offers.
- ESOs also improve employee retention. This will allow human resources and management to focus on building the business as opposed to hiring new talent.
- Employees are directly rewarded for the growth of the company. If the valuation of the company goes up, so does their net worth.
- If employees are offered incentive stock options (ISOs) instead of Non-qualified stock options (NSOs) there are plenty of tax incentives.
However, with pros comes cons. While not as plentiful as the pros of offering employee stock options there still are cons of offering ESOs.
Cons
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 examples above are the most basic forms of tax implications. However the tax structure can get complicated and frustrating for employees.
- The more shareholders you have on the captable the more important dilution becomes. Dilution can be costly for investors and employees on your cap table and will be something startups need to be wary of.
- Valuing stock options can be difficult. At the end of the day, the value is on paper.
- Employees are required to rely on the output of their co-workers and management to make sure their stock is valued as high as possible.
Related Resource: Everything You Should Know About Diluting Shares
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.
How to Issue Employee Stock Options?
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:
- Define the role you are looking to hire. Decide what their total compensation should be. This can be taken from similar job postings and the market as a whole.
- Decide how much of their total compensation you would like to pay in cash (AKA their salary).
- Determine the gap between their salary and total compensation. This is entirely up to the startup or founder. It can be difficult to place a number here as the value of the company is solely on paper. Samuel Gil of JME Partners recommends doubling the value here. For example if there was a $10K difference in their salary and total compensation a startup should offer $20K in added compensation.
- The next step is to determine the exercise price for the stock options. As Samuel Gil writes, “As we have previously reasoned, we will assume that a fair price for the stock options is the same as the price of the common stock. So, how much is the common stock worth? The most frequent procedure is to apply a discount (e.g. 25%) to the latest preferred stock value, since common stock doesn’t have the same economical and political rights that preferred stock (what VCs usually buy) does.”
- Issue the number of shares. This is up to the startup and founder but can be calculated with the logic above. If you find the common stock price to be $5 and need to compensate an employee $20K that would be 4000 shares. This can be quite subjective as we need to remember dilution and valuation can rapidly change.
Related Reading: How do you Determine Proper Compensation for Startup CEOs and Early Employees?
How Are Stock Options Taxed?
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.
What Happens When Employee Stock Options Are Exercised?
We’ve covered what stock options are, how they are issued, how they are vested, and how they can be a benefit for both employees and startups. 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.
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.
Employee Stock Options Terms You Should Know
As we’ve alluded to throughout the post, there are quite a few terms, conditions, documents, etc. that all parties should be familiar with when navigating their employee stock options.
Below are a few employee stock options terms you should know:
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. While more common, NSOs require someone to pay more taxes. NSOs are taxed when exercising and selling their shares.
Restricted Stock Unit — Restricted stock units are grants of stocks a company will offer employees that do not require purchase.
Employee Stock Ownership Plans — Employee stock ownership plans is a retirement plan for employees. Employers contribute stocks to an ESOP account over a scheduled period. An employee participating in an ESOP plan never buy or holds the stocks while being employed by the company.
Employee stock options are an integral part of a startup’s success. ESOs are a powerful tool to attract and retain top talent. In order to best set up your ESO plan, you need to understand the basics of employee stock options. To learn more about attracting and retaining top talent, subscribe to our Founders Forward Newsletter We search the web for the best tips to attract, engage and close investors, then deliver them to thousands of inboxes every week.
