Startup Stock Options

Welcome to Phase Two of a four-part Splitting Equity Series. If you missed it, start your journey here: Introduction - Early Startup Equity — Getting it Right before continuing on if you haven’t already, and go in order from there.

Phase One - Startup Equity - Avoiding Early Mistakes 

Phase Two - Part 1 - How Startup Equity Works 

• Part 2 - Startup Stock Options ( ←YOU ARE HERE 😀)

• Part 3 -Startup Stock Vesting

• Part 4 -Startup Stock Valuation

Phase Three - How to Split Equity

Phase Four - Equity Management

Let's continue!

Startup stock options provide the holder the option to buy a company's stock at a later date, typically during a "liquidity event" where the company is sold or goes public. Early-stage startups use a stock option agreement to provide their startup employees with potential upside based on the company's future success.

Two Types of Startup Stock Options

We're going to cover two types of Startup Stock Options — Traditional Employee Stock Options and what is known as Phantom Equity Grants which have some of the benefits of equity stock options without having to give away actual equity.

1. Employee Stock Options. Stock option agreements most companies set up to issue startup equity to most employees. Employees have the option to buy stock at a later date, but not the requirement.

2. Phantom Equity. A contract right that allows employees or holders to get a percentage of the proceeds of a sale, similar to a stock right, without having to hold any stock (which has pros and cons).

Let's explore both options and see what might be best aligned with your needs.

Employee Stock Options

Since the Stock Option Agreement itself is just an option to buy stock, not the actual common stock (or equity) early-stage startups issue these to early employees (and later ones!) to provide some equity benefit without some of the drawbacks.

When we think about issuing company stock, we're always considering whether we are giving up control of the company as well as what the actual value will be to those receiving stock awards.

Benefits

• Minimizes “loss of control” issues compared to equity

• Can be easily returned

• Minimizes tax consequences for employees

• The Stock Option Grant is already a well-known component of compensation packages in an early-stage company

Drawbacks

• Employees may not be able to exercise them

• Requires us to value the company

• May create dormant equity holders

Strike Price

Most Stock Options have something called a “strike price” (or “exercise price”) which is the purchase price at which a holder (like a startup employee) can purchase their options. For example, if the Strike Price were $1, a prospective employee would have the option to buy stock in the company for $1 per share.  

• If the company were worth less than $1 per share, our stock options would be worth nothing.  

• If the company were worth $3 per share, such as at the time of a sale, we would buy the stock options for $1, sell them for $3, and make $2 per share in profit.

Startups will issue stock options with a strike price so that new employees can benefit from the increase in value of the company. If we join the company with a strike price of $1 and the share value of the company never exceeds $1, chances are we’re not going to enjoy any benefit because the company didn’t “improve in value” during our tenure. 

Benefits of Stock Option Agreement

Stock Options hold a handful of key benefits over handing out regular equity so let’s focus on those first:

1. They don’t impose a control issue (yet). 

   Unless the stock option is exercised, the holders will typically have no specific rights within the company such as voting or other control-based issues. This is different than a venture capital investor who will have preferred stock and control rights. 

2. They can easily be returned. 

   If an early employee leaves and decides not to exercise their options (which will typically have a monetary cost associated with the Strike Price) then those remaining stock options are forfeited, and the stock goes back into the kitty to reward a future startup employee.    

3. Less tax consequence. 

   Being granted Stock Options may not be a taxable event until exercising stock options, at which point a whole slew of taxable challenges present themselves which we’ll need to familiarize ourselves with. What’s important here is that the taxable consequences won’t typically trigger until we have the options granted and exercised, which would only likely happen if there was an initial public offering (IPO) or sale to trigger them.

4. Everyone understands them. 

   Fortunately, the concept of “stock options” has become standard fare within the startup world (often among venture-funded startups), and therefore even if a startup employee has never actually received a stock option before, they will most likely understand how employee stock options work.

Drawbacks of Stock Options

Generally speaking, the benefits of issuing stock options tend to outweigh the costs, but that doesn’t mean there aren’t important considerations with issuing stock options. Let’s take a look at a few of the challenges.

1. Employees may lose benefits. 

   If someone works for the company for 4 years, leaves without exercising their options, and the company sells 3 years later, they may receive no benefit at all. That could be a tough pill to swallow for folks and may not align with how we want to compensate people. (Note, there are some ways to mitigate this, but things get more complex.)

2. Requires a valuation. 

   In order to set a Strike Price for the employee stock options, we would need to know what the valuation of the company is (to price the option). This may be very difficult to do at this stage, and we run the risk of pricing it too high or too low. If you've raised funds, you'd likely use the last round of valuation. When there is no "market" for a company's stock, determining a fair market value is a challenge.

3. May create dormant holders. 

   This is less likely than with handing out regular equity (because everyone will automatically “just own” regular equity) but in the event that we have people that exercise their options but do not materially participate going forward, we may begin to accumulate a dormant cap table. We’ll talk about this problem a lot more later.

Overall, stock options are a great way for us to provide financial upside in the event of a sale or public offering.  That said, they aren’t the only way we can accomplish this goal. We still have another way of offering upside without necessarily having to hand out equity. We call this “phantom equity.”

Stock Option Pool

Once we divide up our own stock, we’ll likely want to award stock to future employees and other contributors down the road. There’s just one problem – it’s a huge pain in the butt to divide up the pie and recalculate everyone’s ownership stakes every time we add another person!

Instead, we can save ourselves some headaches and allocate what’s called a “(Stock) Option Pool” for future awards. Here’s how it works.

Sandy and Ritika are planning on issuing stock to future employees. They’ve decided that they will set aside 15% of the total company’s stock which will reduce each of their shares by 15% of whatever they currently hold. From that point on, as new employees are awarded stock, the shares come out of that 15% pool and don’t affect the stakes.

4 Concerns of a Stock Option Pool

1 - How do we know how much to allocate? 

15% is fairly standard but it can be adjusted later.  If we run out we can simply determine how many stock options we need and allocate more.

2 - What if 15% isn’t enough? 

There’s no way we could possibly know how much to allocate until we actually give it all away (or don’t) so think of 15% as just a placeholder to get the process started.  We can modify it later if we run out.

3 - What happens if we run out and need more?  

When Sandy and Ritika first allocated the Option Pool, it came out of their stake. However, at a later date when the option pool is set up again, it will likely be pulled out of the current holder’s stake, which may include many more people than just Sandy and Ritika. For this reason, it may be wise to not make the Option Pool too big because it may disproportionately dilute the early members versus fairly diluting all members when it’s created later.

4 - What happens if we have some left over? 

Typically, any remaining stock from the Option Pool that isn't allocated will be divided back to the rest of the company — not just to the people who provided the stock (typically the Founders).

Investors will Require an Option Pool

If we wind up raising capital from professional investors they will almost certainly require a
Stock Option Pool to be established, and here’s the kicker — they will require it to come out of our portion of the stock, not theirs. Oh, you sneaky investors!

Key Takeaway: Set up an Option Pool by allocating a specific % of the current stock for future employees.  

It’s worth noting that we can also just punt this decision altogether and not have an Option Pool.  The pool isn’t required, but it’s a fairly common practice among startups to issue equity to employees.

Phantom Equity

Aside from sounding like a really cool version of equity, “phantom equity” or “synthetic equity” is simply a contract between the unit holder (employee, advisor, 3rd party) and the company. The reason it’s called “phantom” or “synthetic” is that it works to achieve the same outcome — paying out a share of upside — without converting to actual equity units.

Phantom Equity works very similarly to a stock option in that it is typically only “exercised” when the company is sold or goes public.  It can also be modified to help make cash distributions (dividends) but that’s a whole other discussion.

Example

If Derek Zoolander is issued 10,000 shares of the company in Phantom Equity, and the company has 100,000 total shares outstanding, he will receive 10% of the payout if the company sells.

The reason we might choose to issue a Phantom Equity plan may have a lot to do with how we want to maintain long-term control of the actual equity in the company, ranging from who will have ownership rights (like equity holders do) to how easily we want to manage the program long term.

When to use Phantom Equity

When we want to provide the benefits of stock without having to give actual equity ownership units of stock.

Benefits

• No dilution of actual equity

• No tax consequence to recipients upon grant

• Avoids dormant equity issues

Drawbacks

• Investors won’t take this form of stock  

• Employees may not understand it vs. typical equity

• Employees are taxed as “ordinary income” vs. “capital gains”

Benefits of Phantom Equity

Phantom Equity’s benefits are really the inverse of many of the painful drawbacks of issuing regular equity or stock options:

No dilution of actual equity

Because phantom equity is a contractual right, not an equity stake, we can issue the benefit of upside without having to issue actual equity ownership. This is particularly important if we want to separate “ownership structure” from “upside structure.” We may want our employees to get all the benefits of upside, but not require them to materially participate in the ownership of the company.

No tax consequence upon grant 

A significant challenge in granting equity is that it has a real market value which is often taxable upon transfer. A phantom equity unit is the “contractual right to a profit” but isn’t an owner of any actual “gain” unless money is exchanged. For example, a salesperson doesn’t get taxed on how much commission their comp plan “might” earn — they are taxed when they are actually paid something.

Avoids dormant equity issues 

Since phantom equity isn’t actual equity ownership of the company, technically the Cap Table never changes. The same owners are the same owners. That said, there could still be a liability to the company if the phantom equity holders leave and still have provisions in their agreement to be paid out for some extended period of time. This is known as a “lookback period” and we’ll cover this in detail in Phase 4.  

Once again, many of these benefits are particularly useful to founding teams that would like to maintain control of the equity membership of the company long term. This tends to be common amongst companies such as professional services firms or closely-held private businesses (not necessarily small ones) that don’t anticipate adding lots of outside members such as investors.

Drawbacks of Phantom Equity

A lot of the challenge around phantom equity begins with a lack of understanding in the marketplace. Unlike regular equity and stock options which everyone has heard about, chances are when we hand a new employee an offer of “phantom equity” they will scratch their heads at first.  

Similarly, investors will almost certainly balk at taking phantom equity over regular equity. However, that doesn’t mean we can’t offer investors regular equity and employees phantom equity. It’s not one or the other.  

1. Not investor-friendly

   Investors aren’t going to be interested in phantom equity because they very much want both ownership and the rights that come with equity — and deservedly so. We can still take on investors but we would need to offer them regular equity.

2. Not well-understood in the market

   We may find that potential employees and partners ask a lot more questions about what a phantom equity plan is than the value of their grant. We would need to be prepared to have a standard explanation of how the program works.

3. Employees are taxed as “regular income”

   While there are many benefits to phantom equity, the preferential tax treatment isn't one of them. Unlike regular equity gains which in the United States enjoy a typically lower rate of taxation (“capital gains tax”) than regular income tax, any benefit paid out under a phantom equity program is simply regular taxable income to the recipient.  

The one other caveat worth mentioning around phantom equity is that not every attorney understands it either. If we’re interested in setting up a phantom equity plan, we’ll want to work with an attorney that is well-versed in this particular type of program so that they can properly guide us through the inner workings.

Equity Now, Options Later

During formation, we probably only need to worry about the Founding team who will likely all be equity holders. We’re going to consider some provisions amongst that team around the “vesting schedule” of that equity (in the next section) and some provisions for how to manage that equity (in Phase 4) but we’ll certainly begin with regular equity no matter what.

Key Takeaway

We’ll start with equity for the original owners and make a decision as to whether we want to issue stock to employees as “stock options” or “phantom equity.”

If we can’t agree on or don’t have an immediate need on how we issue incentive stock options to future contributors, that’s OK. We can set that program up later when we feel we have a need to think through it thoroughly.