What Are Employee Stock Option Plans and Why Do Startups Issue Them?

Are you an early-stage startup founder on the lookout for the best compensation package for your early team members? If the answer is yes, you have arrived at the right place.

Today, we will understand how employee stock option plans work and how they’re granted. Are they lucrative or just a trick deployed by startups to attract talent? If you know how employee stock option plans work in companies, you are off to a good start. However, it is important to note that there isn’t a stark contrast in how stock options work in startups and later-stage companies. Therefore, you should keep a few things in mind while understanding the ins and outs of startup equity.

We will take you through the basics of employee stock options in a startup from the perspective of a founder or an early-stage startup employee. We will take a closer look at how startups calculate the value of common shares while granting options. In addition, we will also understand how to explore your options as an employee when an IPO-like event is not on the cards soon.

Employee Stock Option Plans Explained

So what exactly are stock options? When did they become so popular across startups? Stock options garnered popularity across venture-funded startups somewhere around the mid-70s. When startups were finding it difficult to attract and retain the best talent, offering stock options emerged as a great way to deal with this problem.

Instead of offering high compensation packages, startup founders resorted to giving away a small portion of the company’s ownership to their employees. It was a win-win situation for both parties; startups saved a lot of capital, and employees earned thousands of dollars with this approach. Recently, popular tech startups such as GoGuardian and MineralTreehave offered a small percentage of the firm to their equity pool with great success, making stock option plans an exciting option.

In a nutshell, employee stock options is an equity compensation that gives employees an option to purchase a certain number of company shares at a particular price.

Different types of startup employee stock option plans

By now, you must have understood what stock options are and why startups deploy these options. So let’s look at the two of the most common stock option plans given to employees working at an early-stage startup.

The two options include:

• Incentive stock options (ISOs)
• Non-qualified stock options (NSOs)

You may be wondering what the difference between the two stock options is. While we are not diving deep into the abyss to understand how they differ, let’s run through the basics.

ISOs

Typically, ISOs are offered only to employees. Moreover, they become eligible for preferential tax treatment if they meet certain criteria.

NSOs

There are no restrictions involved here. NSOs are not eligible for the same favorable tax treatment as ISOs. Additionally, they are also taxed at a regular income tax rate.

Apart from NSOs and ISOs, an early-stage startup’s cap table can also include different types of equity, including preferred stock, common stock, restricted stock units (RSUs), and restricted stock awards (RSAs).

Why do startups offer stock options?

On most occasions, companies offer stock options for one of the following reasons:

• Stock option plans have emerged as a cost-effective employee benefit plan in comparison to cash compensation.
• Stock options motivate employees to perform better.
• This approach has enabled startups to pull and retain the best talent for decades.
• Following up on the previous point, stock options allow smaller companies to compete with established brands to create an exceptional workforce.

Takeaway

Startups offer stock options for a myriad of reasons, and attracting top talent remains high on the pecking order. As a result, it has become a key component of compensation packages and an important factor in choosing one company over another.

There is a simple formula you should keep in mind. If the startup does well and makes profits, employees profit as well. Hence, stock option plans are a great way to build a loyal partnership with employees. As mentioned earlier, this approach is an excellent way to keep employees motivated. However, you should understand that stock option plans come with no guarantee. There are risks involved, and there is a chance of losing the entire principal you have invested.

Thus, it is critical to research, evaluate the company’s growth trajectory and vision, and determine whether they align with your goals.

Visit trica for ESOPs and cap management. We are a trusted partner of over 800 startups. Request a demo to learn more about our services.