If you own or work for a start-up, you’ve likely broached the topic of stock options. Yet, with so many different plans out there, it’s important to understand the basics behind options in order to figure out just what your stock option plan really means.
Most start-ups are potential-rich yet cash-poor so the idea behind stock options is to give people the opportunity to benefit from the future value they create at your company. You’re essentially giving somebody the option to own a portion of your business at some point down the road. However, instead of giving away a piece of the pie directly, the concept behind the option is to set the conditions under which that person gets to become an owner.
For example, suppose you give away 5% of your company to your first employee Jane. If Jane quits after the first week, you’re not only down an employee, you’ve also just lost that 5%. Ideally, you’d want to set a bunch of conditions before you give Jane any ownership- perhaps you want her to be with the company for a certain amount of time or perhaps you don’t want her to able to vote in board meetings. The idea behind stock option plans is to set the terms under which Jane receives her stock or percentage of ownership of the company.
Most stock options have three basic components: the stock amount, an exercise price and a vesting period.
The stock amount is the amount of stock that you’ll own once you exercise (basically use or activate) the option. The percentage that you’ll own after receiving your stock depends on how many shares are outstanding in the company.
For example, if Startup Inc. has 100 common shares outstanding and provides 10 common shares to Jane, Jane will own 10% of the company. Keep in mind that things can get quite a bit more complicated as companies have the ability to issue more shares and change that person’s ownership (called dilution), but we’ll keep things simple for now.
An exercise price is the price at which the person acquires the stock. In our example above, if Jane can acquire the stock at an exercise price of zero, it means she receives her 10% of the company for free. On the other hand, if Jane’s options come with an exercise price of $10, she’ll need to pay $100 (10 shares x $10) for her piece of the pie.
The vesting period is the amount of time you’ll need to wait before you actually receive your ownership. If Jane’s option to purchase 10 shares at an exercise price of $10 has a vesting period of 3 years, she’ll need to wait that amount of time before she can actually make the purchase.
The act of exchanging your option for actual stock is generally done through the company’s legal team. Typically once the vesting period is up, you’d be in touch with the company’s lawyers and they would send you the paperwork to reflect the trade of the option for the actual shares.
While those are the basics of stock options, there are plenty more conditions out there. You can control what happens when an employee leaves, what voting rights they have, who they’re able to sell their shares to, etc. As option plans can be quite involved, make sure you go over your plan in detail upon receiving any stock options or look for some advice before creating any kind of stock option plan so the conditions you set are aligned with the goals you’re looking to achieve.