What are stock options?

Takeaway: Stock options are an effective way for startups to compensate employees and consultants. Options are not ownership of stock - they are an option to purchase stock. Option holders have to pay an exercise price in order to purchase their shares. Companies usually issue restricted stock awards to employees and consultants until the price of the stock gets to be too high for them to pay for the shares and then, going forward, the company issues options.

Stock options are a type of equity compensation commonly used by startups to attract and retain talent. Essentially, a stock option gives the recipient the right to purchase a certain number of shares of the company's stock at a predetermined price, known as the exercise price. Stock options are generally issued by companies once the price of their stock becomes impractical for employees to purchase shares directly (e.g., after a preferred stock financing).

Here are some key features of stock options for startups.

Vesting

Like other forms of equity compensation, stock options typically vest over time, meaning that the recipient must work for the company for a certain period of time before they can exercise their options. Stock options for employees are typically structured with the same 4-year vesting with a 1-year cliff as the stock held by the founders. Vesting of stock options for consultants are often different though and depend on the term of the consultant’s services to the company.

Exercise price

The exercise price of a stock option is typically set at the fair market value of the company's stock at the time the option is granted, which is reflected in the company’s then-current 409A valuation. It is not recommended for startups to issue options without a valid 409A valuation. There can be severe tax penalties for mispricing stock options and relying on a valid 409A valuation puts you in a safe harbor to avoid these penalties.

Tax implications

Depending on the type of option and the specific terms of the arrangement, there may be tax implications for both the company and the recipient. A common question I get is whether stock or stock options are better for tax purposes. The answer is that stock is generally more favorable to the employee because the long-term capital gains holding period begins when the employee receives the stock. With a stock option, the employee doesn’t own the stock for tax purposes until they exercise the option. Since exercising options can involve a significant cash outlay, employees don’t generally exercise until the company is being sold, which typically results in the proceeds from the sale of their shares being taxed at short-term capital gains rates (i.e., ordinary income rate) instead of long-term capital gains rates.

Types of options

There are two main types of stock options used by startups: incentive stock options (ISOs) and nonqualified stock options (NSOs). ISOs are generally more favorable from a tax perspective, but they are subject to more restrictive requirements including that only employees of the company can receive ISOs.

Stock options in startups are typically issued pursuant to an equity incentive plan, which usually provides that the company may only issue stock options under they plan to individuals (not to entities). It is possible to issue a stock option to an entity outside of the equity incentive plan, but the company will need to find appropriate securities law exemptions to do so.

Conclusion

Stock options can be a valuable tool for startups to use to attract and retain talent. By giving employees the opportunity to purchase shares of the company's stock, startups can provide a powerful incentive for employees to work hard and contribute to the company's success. If you are a startup considering offering stock options, it's important to work with a qualified attorney and tax professional when issuing this equity compensation.