How to Create an Employee Stock Option Plan
- Setting Up Your Employee Stock Option Plan. The first step in setting up your employee stock option plan is to develop your philosophy around your stock option plan.
- Maintaining Your Employee Stock Option Plan. Once you create your employee stock option, you can’t set it and forget it. ...
- Making Offers of Stock Options. Companies also tend to make some crucial mistakes at the point of making offers of stock options to their employees.
- Finalizing Your Grants. Your company must follow through and ensure that the board approves each employee’s stock option grants.
How many stock options should you offer employees?
The pitfalls of employee stock options
- They are often offered by start-ups. Employee stock options are often offered by startup companies because they cannot afford to pay market level salaries.
- The company’s stock could collapse. ...
- There could be a multi-year bear market in stocks. ...
- The employer can fail. ...
- Termination prior to vesting. ...
- You could be putting all of your eggs in one basket. ...
Do stock options really motivate employees?
Many business owners find that offering stock options to employees improves morale. When employees are given a share of ownership in the company, they will enjoy coming to work. They know that their efforts will directly impact their financial situation and will be more willing to work together.
Why do some firms give stock options to all employees?
Why Do Companies Offer Stock Options?
- Company Stock Options. Employers can offer company stock options to employees, including those in managerial and rank-and-file positions.
- Attract Talent. Companies, including small businesses, offer employees stock options as a means to attract the highest possible talent.
- Talent Retention. ...
- Incentive. ...
What should I do with my employee stock options?
- What are your expectations for the stock price and the stock market in general?
- How much time remains until the stock option expires?
- If you are within 120 days of expiration, it may be time to act, to avoid the risk of letting the options expire. ...
What are typical stock options for employees?
There are two main types of stock options that companies award to their employees: incentive stock options, or ISOs, and nonqualified stock options, or NSOs. The most significant difference between the two is in the tax treatment.
How do you manage employee stock options?
6 Strategies to Consider to Exercise Your Employee Stock OptionsCase 1 – Exercise and Sell Your Stock Options As Soon As Possible.Case 2 – Wait Until Your Stock Options Are About to Expire.Case 3 – Exercise Your Employee Stock Options and Hold Shares.Case 4 – Exercise and Sell As Your Concentrated Position Increases.More items...
How do stock options work for employers?
Stock options are a form of compensation. Companies can grant them to employees, contractors, consultants and investors. These options, which are contracts, give an employee the right to buy, or exercise, a set number of shares of the company stock at a preset price, also known as the grant price.
How do I create a stock options plan?
1: SetupDevelop your philosophy. Your stock option plan is an expression of your company philosophy. ... Paper it. Adopt your stock plan and option agreements and get board and stockholder approval. ... Make it official. Work with your lawyers to obtain all relevant state permits for your option plan.
How much does it cost to set up a stock option plan?
ESOPs are costly to set up ($80,000 to a few hundred thousand dollars), but less costly than the sale of the company to another buyer. Their ongoing costs are not a significant factor for the large majority of companies.
How do stock options work for employees in private company?
Private company stock options are call options, giving the holder the right to purchase shares of the company's stock at a specified price. This right to purchase – or “exercise” – stock options is often subject to a vesting schedule that defines when the options can be exercised.
Are stock options good for employees?
Basically, as the company profits, employees profit as well. Thus, stock options are a way to create a loyal partnership with employees. Stock options are a way for companies to motivate employees to be more productive. Through stock options, employees receive a percentage of ownership in the company.
Why do employees want stock options?
Stock options are a benefit often associated with startup companies, which may issue them in order to reward early employees when and if the company goes public. They are awarded by some fast-growing companies as an incentive for employees to work towards growing the value of the company's shares.
What are employee stock options?
Stock options serve as a form of compensation that a company offers to employees. Rather than providing them shares of company stock directly, the company gives employees the right to buy a set number of shares at a specific, discounted price.
Common stock option terms
When navigating employee stock options, you may encounter unfamiliar terms. This list outlines some of the common terms you may hear, along with their definitions:
Types of stock options
Employers offer two types of stock options to their employees. The main difference between these two options is the tax rules that apply to them:
Example
You can use the following example as a demonstration of how employee stock options work:
Why do companies offer stock options?
As a small business, you can consider offering stock options as a great way to compensate employees and help build a hardworking and innovative staff.
Why do people have stock options?
Stock options are meant to give employees an incentive to work with a company and invest in its growth. They are a cost-effective way to attract talented candidates and encourage them to stay long-term. Employees who own shares of stock have an additional financial incentive for performing well at work beyond their regular salary. They want to help the company grow so the stock price will go up and they can make a significant profit on their initial employment package.
What are the two types of stock options?
You can offer two kinds of stock options to employees: incentive stock options (ISOs) and non-qualified stock options (NSOs). The largest difference between these two categories of stock options is their tax qualification and eligibility requirements.
Do ISOs have to be paid?
ISOs can only be given to workers who are classified as employees, either full-time or part-time. When an employee exercises an ISO, they do not have to pay taxes right away. Taxes on ISOs are paid when and if the employee decides to sell their shares at a later point in time. After the employee finalizes the sale, they pay capital gains and federal income tax to the IRS. To qualify for an ISO, the employee must hold onto their stock for at least a year after purchasing it and at least two years from initially being granted the stock options.
What is an Employee Stock Option Plan?
Let’s start by reviewing the basics of an employee stock option plan, or an ESOP. Employee stock option plans are a type of incentive compensation that allows individuals the option to buy ownership in the company.
ESOP Terminology
Before we get into how you can set up your stock option plan, let’s go over some basic ESOP terminology.
When to Issue the ESOP
The next thing you need to consider is when to issue your ESOP. The answer to this will vary depending on what stage your startup is in.
How to Structure an ESOP
When you start to structure your employee stock option plan, there are various things to consider, such as how much equity you will set aside and how you will allocate tiers.
What is employee stock option?
Investopedia defines employee stock options as, “a type of equity compensation granted by companies to their employees and executives. Rather than granting shares of stock directly, the company gives derivative options on the stock instead.
Why are stock options important?
Employee stock options are vital for all startup founders and employees to understand. For startup employees the benefits often come in other forms than salary — one of the major ones being ownership in the company. Discussing stock options and compensation plans can be intimidating — especially for first time founders or employees working ...
What is vesting schedule?
A vesting schedule usually takes place over a period of time and may be split over the course of a few years or milestones. The most common vesting schedule for startups is a time-based schedule. This means that you’ll receive a set amount of shares over a set amount of time.
What is vesting in retirement?
As defined by Investopedia, “Vesting is a legal term that means to give or earn a right to a present or future payment, asset, or benefit. It is most commonly used in reference to retirement plan benefits when an employee accrues nonforfeitable rights over employer-provided stock incentives or employer contributions made to the employee’s qualified retirement plan account or pension plan.”
What is non qualified stock option?
As defined by Investopedia, “a non-qualified stock option (NSO) is a type of employee stock option wherein you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option. ”.
What is an ESOP plan?
As defined by the SEC, “An employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock (or money to buy its stock) to the plan for the benefit of the company’s employees.
What happens if you sell shares immediately after exercising?
However, if you sell your shares immediately after exercising you will be taxes at the ordinary income level (similar to Non-qualified stock options). ISOs are generally awarded to high level managers and high value employees. For a startup, this usually means the early employees and founders.
Valuing Stock Options for Startup Employees: Introduction
It's quite common for those who have been offered positions with startups to be given stock options to make up for low or modest salaries. Startup companies are known for aligning investor, manager, and employee incentives. When the business does well, so do the employees.
What Are Stock Options?
A stock option is a financial instrument and a privilege, sold by one party to another, which gives the buyer the right, but not the obligation, to sell or buy an underlying asset at an agreed-upon strike price within a certain period of time. The strike price at which the options are granted is usually the current market price.
What Are Stock Option Plans?
Employee stock options allow employees to take part in the company's success without requiring the company to expend precious capital during the startup process. In fact, employees are usually required to pay the exercise price for the options, which helps to contribute to the company's capital.
What Are Stock Options Worth?
The value of a stock option is the sum of its time value and intrinsic value. Upon being granted, the intrinsic value of the options is zero and all their value is time value. Upon being issued, the options usually have no intrinsic value.
Making the Assignment
How many employee stock options should be granted? The assignment of stock options is usually a five-step process:
Why are stock options good for employees?
Stocks are relatively low-risk for employees. “Stock options are great because employees participate in the upside without taking on any downside risk ,” James Seely, head of Marketing at the ownership management platform Carta tells Startups.co.
How long should stock options be covered?
Experts recommend that this gap be covered for generally around two years — but each company’s mileage may vary.
What are the disadvantages of stock options?
Stocks are really tricky. “The first disadvantage of stock options is that they are complicated and most employees require a base level of education to understand them,” James says. “Many of the companies we work with at Carta invest in educating new hires and periodically host training sessions for existing employees.”.
What does it mean to be a partial owner of a stock?
A stock is a portion of ownership in a company and, for some people, being a partial owner is a great motivator for working even harder. People feel a greater sense of investment and pride in anything — a house, a business, a car — when they own it.
What is restricted stock?
Restricted Stock: “shares in a company issued to employees as part of their pay, but which cannot be fully transferred to them until certain conditions have been met.”. Shares: “a part or portion of a larger amount that is divided among a number of people, or to which a number of people contribute.”. Stock Options: “a benefit in the form of an ...
Can stocks make up a gap?
Stocks can make up a gap between salary and market rate. Startups can offer a lot to employees. The chance to work on something new and exciting. More flexibility in the workplace. “Casual Friday” every day. But one thing many startups can’t offer is a salary that meets market rate.
What is a stock option?
Mechanically, a stock option was a simple idea – an employee received an option (an offer) to buy a part of the company via common stock options (called ISOs or NSOs) at a low price (the “strike price”).
When did investors give stock options to the founders?
By the mid-1970’s, investors in venture-funded startups began to give stock options to all their employees.
What is restricted stock unit?
Restricted Stock Units are a company’s promise to give you shares of the company’s stock. Unlike a stock option, which always has a strike (purchase) price higher than $0, an RSU is an option with a $0 purchase price. The lower the strike price, the less you have to pay to own a share of company stock.
What are the negatives of starting a startup?
Add to that all the other known negatives of a startups: no work-life balance, insane hours, inexperienced management, risk of going out of business, etc. That said, joining a startup still has a lot of benefits for employees who are looking to work with high-performance teams with little structure.
Can employees own stock options?
If the company was successful, the employee could sell the stock at a much higher price when the company listed its shares on a stock exchange (an “initial public offering”) or was acquired. Employees didn’t get to own their stock options all at once.
Did founders have more stock than employees?
While founders had more stock than the other employees, they had the same type of stock options as the rest of the employees, and they only made money when everyone else did (though they made a lot more of it).
1: Setup
This section describes the upfront investment you’ll need to make in order to issue options to your first set of employees.
2: Maintenance
This section describes items you’ll need to monitor on an ongoing basis.
3: Making offers
This section provides a checklist for making a prospective employee an option grant.
4: Finalizing Grants
This section describes the dotting of the i’s and crossing of the t’s.
Conclusion
Founders are busy. There are hardly enough waking hours in the week to work on your core mission, never mind spending time on administrative tasks. However, this stuff matters. Running your company well can sway investors, help you hire great employees, and reduce the chance of missteps that can hurt or even kill your startup.
Further reading
Best Practices for Option Grants by Venture-Backed Companies https://www.wilmerhale.com/pages/publicationsandnewsdetail.aspx?NewsPubId=87005
