STOCK OPTIONS 101

You would not believe the number of questions I get on stock options. I've thought about it and have come up with the following reasons as to why so many people get tripped up on these:

1. Things that are not concrete and are potential in nature add an air of mystery and confusion. 

2. Someone either explains options in extremely basic terms: "A stock option is an option to purchase stock." Okay, thanks bro. Or the explanation is too thorough. You go to the library to learn about it and you get handed a giant book by the librarian that you'll never read that covers a million scenarios that aren't relevant to you.

Annoying. So here's what I'm going to do. I'm going to give you a thorough explanation, but not a book. So here it is.  

Table of Contents

I. Stock options basics

A. What are stock options?
B. Why use stock options?
C. Who gets stock options?
D. How do stock options work?

(i) Granting of the option
(ii) Stock option timing

II. Other stock option issues

A. When should stock options be issued?
B. Stock option pool
C. Giving stock flat-out vs stock options
D. The two types of stock options and why it matters

III. Stock Options 101 summary and more reading

I. STOCK OPTIONS BASICS

A. What are stock options?

A stock option is the right to purchase a certain number of stock of a company at a specific price in the future. This is in contrast to buying stock at whatever price the stock will actually be in the future. 

Here's an analogy: if I give you the right to buy a bucket of widgets for a specified amount of $1 in two years from now regardless of what is to happen, and two years from now the actual price (market value) of a bucket of widgets is $5, then your ability to purchase the widgets at $1 is extremely beneficial to you. You get to purchase at a big discount. Additionally, you can do what you like. You can hold on to the widgets. Or sell it for a nice profit seeing as you got to buy at $1, while everyone else has to buy at $5. 

This is similar to the stock option scenario: the hope for a stock option holder is that the specified purchase price will be much lower than the market value in the future--so that the option holder can purchase the stock at a massive discount. The whole thing is premised on the idea that the value of the company goes up in value as time goes on. Additionally, just as the option to buy widgets is NOT actual widgets, a stock option is NOT actual stock. 

Having a stock option is a beneficial thing. Employers give out stock options of the company as a way to compensate employees, consultants, and others for their work. They are good incentives for employees because they provide employees potential upside in the company's growth as well as allow employees to be a part of the startup as an equity holder instead of just some random dude who gets paid for their work. 

B. Why use stock options?

A startup or company issues stock options for a few reasons:

- To give people a stake in the game. Motivations are different if you are simply an employee vs an employee AND a stockholder/owner of the company.
- To incentivize employees to stick around with the company and to not just leave
- To allow others to share in large potential upside of the company's growth
- To compensate employees when the startup is in its infancy and doesn't have much cash to pay its employees; or the company just doesn't want to use too much cash to acquire top talent.

C. Who gets stock options?

Stock options are issued by the company to mostly employees, directors of the board, and some times to consultants and other advisers. 

D. How do stock options work?

Stock options give employees the "option" to purchase a certain number of common stock in the future at a certain price at a certain time. The specified price is called the exercise or strike price and is the fair market value (FMV) of the common stock at the time of the grant.

So if the option is granted at the FMV of $1 and down the road the value of stock is $2, the employee can still purchase the stock at $1. If instead the value of the stock drops before the holder exercised, then the option is considered "underwater." Nothing really happens. The holder can still exercise, but the holder would be paying more for the stock than it's actually worth. These values are generally difficult to determine and most holders actually exercise when there is some liquidity event on the horizon (and when the value may be more readily determined.) 

(i) Granting of the stock option

The employer gives the employee or recipient a legal document called a stock option agreement. This has all of the details about the stock option including the number of shares the employee is allowed to purchase, the strike price, and timing issues such as the expiration date.

The number of shares is capped at a maximum number that the employee can buy. The strike price (sometimes called option or exercise price) dictates the price that the employee can purchase the shares at. Regardless and even if the stock price goes up in value, the price that the employee gets to purchase at is the strike price. 

Basic example: You take a job at a startup that gives you the option to purchase 1,000 shares at $1. The company starts to do well and the value of the stock is $5. You decide to act on this. So you purchase the 1,000 shares at $1. Now you have shares with a total value of $5,000 even though you spent only $1,000.

(ii) Stock option timing

Vesting 

The company wants to provide incentive to the employee to stick around. 

The startup wants to avoid a situation where it grants an employee 10,000 shares in a stock option on Day 1.; on Day 2, the employee exercises its option and purchases 10,000 shares; and then on Day 3, the employee decides "screw this" and leaves. 

The way the company gets employees and other option holders to stick around is by not allowing the option holder to purchase stock until some certain time has passed. This concept is called vesting. Vesting refers to when the shares are actually available for the employee to purchase. 

Stock options are generally subject to a vesting schedule. That is to say--the employee is not able to purchase stock until a certain amount of time has passed. As time passes, some of the option "vests" and the employee is able to use the option to buy some stock. As more time passes, more of the option vests and the employee is able to use the option to buy even more stock. At the end of the vesting timetable, they are able to purchase all of the stock specified in the grant. 

There may be acceleration clauses in place too. In the case of an instance such as a sale of the company, the vesting schedule may be sped up and the holder will be able to more quickly exercise the options. Single trigger acceleration requires the happening of one event (e.g. sale of the company) and double requires two (e.g. sale + termination.) This will be defined in the agreements.

The reason for a vesting schedule is because the startup wants to avoid a situation where the startup allows an employee to buy stock, the employee actually purchases the stock, and then the employee immediately leaves. Like I said--the startup wants to give incentive to the employee to stick around. 

A reasonable vesting schedule will allow for some shares to vest in the first year, some more in the second, and so on and so forth for about 4 years when all of the stock option grant has vested. 

Other Timing Issues

There will also be timing issues, particularly timing of exercise, that may be caused by an employee termination, death, or other happening. Additionally, options expire after a certain amount of time (usually 10 years.) These types of issues will be specified in the option grant agreements between the startup and the employee.

II. OTHER STOCK OPTION ISSUES

A. When should stock options be issued

Like I said, stock options allow employees to capture the upside of the company value going up over time.

Therefore, the best time to issue stock options is as early as possible while the valuation of the startup is low. A startup is not a mega corp that has been around for 87 years whose stock value has been going up and down for the last 35 years. A startup is a baby company that perhaps hasn't put out a product yet, or has just begun production, is still growing, etc. The value of the stock should theoretically increase as it meets these milestones. 

In order to allow employees (who you want to keep happy) the most upside, issue these stock options as soon as you can. 

B. Stock option pool

The startup sets aside a certain amount of stock from which the options will be granted. This is typically 10-20% of the startup's stock. 

The smaller the percent, the better for the other shareholders/founders from an equity standpoint. Think of the company as being a pie. If a certain amount of pie is reserved for one group of individuals. There will be less for others. How much to reserve, of course, depends on the hiring needs of the startup. If you need to make a lot of employee hires, the pool size needs to be larger. And of course, the better the talent, the more shares they will want, so keep that in mind. 

C. Giving stock flat-out vs stock options

There are situations when the startup gives out restricted stock (i.e. actual stock subject to vesting) instead of options (the option to purchase actual stock.)

The determination of which to use depends on a number of factors. The restricted stock method is simpler, can be cheaper, but can also mean that certain individuals are immediately made shareholders. There are other factors as well. Employees generally won't really have a say-so on this matter. 

D. The two types of stock options and why it matters

There are two types of stock options--incentive stock options (ISO) and non-qualified stock options (NSO.) 

ISOs are issued according to very specific IRS regulations dealing with a whole bunch of stuff. NSOs are not. The basics for both are more or less the same regarding how they work. The differences that really matter are the way they are taxed and who can receive them. 

Only employees can receive an ISO. Employees, directors, advisers, etc. can receive NSOs. 

Are Incentive Stock Options or Non-qualified Stock Options better?

NSOs are better because: (1) they are simpler; (2) the tax benefits of ISO don't usually matter due to AMT consequences and holding period requirements; (3) NSOs are more flexible. 

III. STOCK OPTIONS 101 SUMMARY AND MORE READING

- A stock option is the right to purchase stock at a specified price in the future. The hope is that the actual price of stock will go up in the future, so that the person getting the option can purchase the stock at a discount in the future.  

- Companies use stock options to give incentive to employees and to compensate them when they don't want to pay out cash. 

- Stock option timing is an area to pay attention to. 

- If you're an employer, read this article on Stock Options for more technical details.

- If you're an employee, or stock option recipient, read this article for more technical details.