During the earliest stages of a startup, many things feel big – ideas, challenges, and potential. Founders attract individuals who believe in and align with the company’s mission and vision. If founders are lucky, these individuals become part of the team.
As founders build their startup’s equity structure, understanding stocks and shares are key aspects of building your team, attracting investors, and protecting ownership. Stock options are often leveraged at various stages because they are not actual shares of the company, but the right to purchase those shares in the future. The option to purchase shares is an incentive for participation, but does not equate to granting immediate ownership.
In this blog, we’ll explore how stock options work, why startups leverage them, founder considerations, and employee stock option plans (ESOPs). We’ll also share how to protect your startup as offers, plans, and contracts are drafted.
Why Startups Use Stock Options
A common startup challenge involves small amounts of working capital. As startups work through various funding rounds, they may not have the ability to offer salaries significant enough to appropriately compensate onboarding talent. This is where stock options come into play; it’s an equity incentive plan that can attract talented employees and advisors who believe in you. This allows the early-stage company to compete with larger established corporations who may offer larger salaries, preserving cash flow. This provides employees with a long-term, high-reward potential.
Having stakes in company equity incentivises employees to think and act like company owners. Stock ownership helps align interest while motivating employees to work hard to drive company success.
If the startup value grows, so does the employee reward. This further incentivizes employees to not only join the company early on, but to stay long term. This increased retention inevitably saves the company time, effort, and money that are all key to successful startup growth.
Founders should consider the startup’s anticipated growth, ensuring all contractual language is clear and aligned for both parties. It is important to have an attorney draft or edit legal documents and agreements at the earliest possible stage to keep founders and their equity properly protected.
Common Stock Option Forms
Founders often reserve a pool of stock shares reserved for employees and advisors. While not distributed directly as shares, stock options allocate the right for certain individuals to purchase shares at a fixed — and typically discounted — strike price in the future.
Unlike equity grants (also known as restricted stock units or RSUs) which represent actual shares of company stock, stock options offer the potential for equity compensation in two different forms, often for two different types of participants.
Founders grant either Incentive Stock Options (ISOs) or Non-qualified Stock Options (NSOs). These forms differ in the way they are taxed and who will receive them. Typically, employees receive ISOs, while advisors or board members receive NSOs, though founders can issue NSOs to employees as well. Both types must be exercised for recipients to receive value, but ISOs offer more favorable tax treatment as regular income tax isn’t triggered when options are exercised. NSOs automatically trigger income tax on the difference between the current market value and the strike price, and value appreciation is also taxed as capital gains.
While either type of stock options does present an incentive to participate in the startup, founders must be clear about vesting schedules and the exercising process. Outlining the type of options, exercise price per share, term of award, expiration date, and more legalese should be a part of the stock option agreement. Some employees find the exercising process cost prohibitive and feel put-off by the founder, so it’s imperative that founders work with attorneys to ensure a thorough understanding from both parties.
When Should Startups Establish Employee Stock Option Plans?
Founders often establish employee stock option plans (ESOPs) before making their first hires, especially when these hires will be integral to company growth. ESOPs generally do not apply to employees classified as contractors or freelancers; however, that could be different if these individuals will make an impactful company contribution.
Early establishment of ESOPs can help build a sense of trust between employer and employee, leading to a greater rate of employee retention and satisfaction. An ESOP can also make teams more invested in the success of a startup, and more likely to want to be a part of that success, as well as more willing to work hard to ensure the business thrives. Early-stage investors often view an ESOP as dedication to building a dedicated core team, which can signal higher potential company success.
Various growth stages may trigger revised ESOP agreements. Funding and hiring rounds can dilute or expand the ESOP pool, but the share value increases relative to company valuation. Shifting ESOP allocations at these stages can allow early contributors to gain more equity while maintaining incentives for new hires.
No matter when an ESOP is created, it is always important to maintain transparency and ensure all fine print is clear and correct. As with any legal document, careful editing and attention to detail is needed to ensure the quality of the agreement and safeguard the startup’s interests throughout the life of the company.
Founder Disclosure Considerations
From an ethical standpoint, founders should be transparent about more than the stock option incentive. Providing employees with a thorough understanding not only positions leadership as a cooperative entity, it also empowers employees to work proactively in the company’s best interest. Conversely, maintaining confidentiality around investment rounds, public offerings, or anything that may alter share value could be considered unethical.
Transparency should be maintained regarding:
- 409A valuations
- Tax implications
- Pending investment rounds
- Initial public offerings (IPOs)
- Dilution impacts
- Exit strategies
Outlining these items in ESOPs not only encourages positive founder-employee relationships, it protects startups by maintaining best practices throughout the company lifecycle. Make sure your attorney includes clear, straightforward disclosures as agreements are prepared.
Let HJF Law Ensure Your Stock Option Plans Maintain Your Best Interest
It’s never too early to hire a lawyer! Our well-versed attorneys bring experience and expertise to the table, and can evaluate your ESOPs and all stock option contracts to keep you protected.
No matter what stage your startup is in, careful planning and attention to detail is key in all legal documentation. Learn more about HJF Law’s startup legal services at hjflaw.com. Call us at (917) 726-8184 for a free consultation to see if we are the right fit for your company.