STOCK OPTIONS FOR EMPLOYEES
As a startup lawyer, I've had a lot of individuals, who are employees, and not founders ask me about stock options, so I decided to write this up.
Here I tell employees straight up how stock options work. If you're an employee, you still need to read the foundational piece regarding how stock options work. Then read this article.
Table of Contents of Stock Options for Employees
A. The Key Documents
1. Stock Option Plan
2. Stock Option Agreement
3. Exercise Agreement
B. Important Clauses
1. Dates
2. Number and Type of Shares
3. Exercise Price
4. Type of Option
5. Vesting Schedule
6. Adjustments
7. Termination Provisions
8. Exercise Options
9. Change of Control Clauses
10. Restrictions
11. Clawback/Repurchase Rights for Vested Shares
C. How much should you get when it comes to stock options
1. The larger the company, the less % of equity you will get
2. The more competitive your salary, the less equity you will get
3. It's all relative
4. Range of equity
D. Exercising Your Stock Options
E. Stock Option Tax Issues
1. Nonqualified Stock Options Tax Consequences
2. Incentive Stock Options Tax Consequences
F. Stock Option Tips and Takeaways
1. You will be getting options for common stock
2. Plan for the timing of the exercise
3. Make sure dates and timings are consistent
4. Watch out for clawback provisions
5. Read in conjunction the stock option plan and other documents
6. Know when you can exercise your options
7. Don't try to negotiate the exercise price
G. Stock Options for Employees Conclusion
A. The Key Documents
Your employer will give you three main documents.
1. Stock Option Plan
This is the overarching general plan that is adopted by the startup regarding issuances of stock options.
It contains the terms and conditions for the stock options on a more general basis. It's the governing document that contains a lot of details regarding the stock options that the startup plans to issue to employees. There will be certain important terms and definitions that you need to pay attention to that you may not see in the Stock Option Agreement
2. Stock Option Agreement
The Stock Option Agreement goes in conjunction with the Stock Option Plan.
The Stock Option Agreement is an individualized document and contains information regarding how many shares the recipient ("optionee") can purchase, the vesting schedule, and other details. It also includes information and form of the exercise.
This is the definitive agreement between the startup and the optionee. It is what gives the optionee the right to purchase stock in the future.
3. Exercise Agreement
Some times this will be attached to the Stock Option Agreement. It has further information regarding the exercise of the option.
B. Important Clauses
There's going to be a bunch of contractual terms and terminology in the documents that you receive. But I want you to pay particular attention to these important clauses and provisions:
1. Dates
Options are all about timing and dates.
Recommendation: Shitty copy and paste jobs create errors that will be obnoxious (if not impossible) to correct later. Make sure all of the dates are correct. Correlate them with the dates of your Employment Agreement. Do they make sense?
2. Number and Type of Shares
The Stock Option Agreement will tell you how many shares are available for the employee to purchase along with what class of shares.
Recommendation: see down below for how much equity you should receive. Don't fret if you will be receiving "common stock" instead of "preferred stock." Receiving common stock for stock options is normal.
Again, correlate all of this with your Employment Agreement. Make sure you get what you're supposed to.
3. Exercise Price
This is the price that you will be able to purchase shares for in the future regardless of what the price of the share will actually be.
Recommendation: Don't try to out-negotiate your employer regarding the exercise price. The exercise price should be the fair market value of the stock at the time of the grant.
The startup needs to abide by IRS rules regarding the exercise price and will figure out the price accordingly. Startups are not interested in making money off employees. Thus, the price should not be above the fair market value. The price also should not be below fair market value otherwise the employee will have tax consequences. If it isn't FMV, then you need to talk to your employer.
4. Type of Option
You will be receiving an Incentive Stock Option (ISO) or Nonqualified Stock Option (some times called Nonstatutory Stock Option or similar.) The documents should spell out which are being granted.
It is possible to receive both ISO and NSO. In that case you would be getting two stock option's'.
Recommendation: I've mentioned before that NSOs are better. If you get an ISO instead don't fret. Unless you are a serious power player and joining the company at the very foundation, you're not going to be able to change this any way.
5. Vesting Schedule
Your options are going to be set to a vesting schedule. If not, good for you.
Recommendation: This needs to be something reasonable--either 3 or 4 or 5 years. Of course lower is better for the employee, but be aware of something more than that.
4 years is the most common and may feature a 1 year "cliff." The cliff means that no part of the option will vest until the first year is over, when 25% of the option will vest. The other 75% will typically vest on a monthly basis thereafter.
6. Adjustments
Adjustments cover what happens in the case of situations such as stock splits.
If the startup does a 2 to 1 stock split (meaning that shareholders are given new shares in proportion to how many shares they have), then the value of stock will drop by half.
Explanation: I will show you why this clause is important. There are 10,000 shares of the startup out there at the value of $1.00. You have the option to purchase 1,000 shares (representing a fair amount of the startup) at $1.00. The company announces a 10 : 1 stock split. Now there are 100,000 shares out there and the value is $0.10. You still have the ability to purchase 1,000 shares (representing a tiny part of the startup) at the price of $1.00
This doesn't make sense. If there's going to be a stock split, combination, recapitalization or whatever of the startup, there needs to be a proportionate adjustment for the options.
Recommendation: This is an extremely important provisions and you can be screwed if it's not included in the documents. Make sure that this is included in the option agreements and that it makes sense.
7. Termination Provisions
If your employment is terminated for some reason, your options will lapse.
Recommendation: Track what happens.
Just because you leave doesn't necessarily mean that the options are done for. Understand what happens to your options if you leave
Get out a spreadsheet/paper or pen/whatever and chart out what happens if you retire, resign, have your employment terminated for cause or without cause, if you get disabled, if you die.
The standard is that you can exercise the option within 90 days after your employment is over (but in no event later than the expiration date of the option.)
If disability or death
You or your estate will usually have a couple of years instead of the 90 days to exercise options.
If termination of employment for cause
I.E. you were fired because of something bad you did, your options will be immediately terminated.
8. Exercise Options
This part will detail how you go about actually exercising the options.
Recommendation: The agreement should spell out exactly how to exercise your options. Look at what the method of exercise is and what the method of payment is. Also pay attention and be aware of any time where there's a lock-up agreement in place. This will prevent you from exercising at certain times.
9. Change of Control Clauses
These clauses detail what happens when or if the company gets sold/acquired or similar.
Recommendation: One of three things will happen. Either the options will be assumed, there will be single-trigger acceleration, or there will be double-trigger acceleration. Single-trigger means that all of the option will vest immediately if there is a single event (such as a change of control.) Double-trigger means that two events are necessary (such as a change of control in conjunction with a termination.) Single-trigger is more favorable for employees.
10. Restrictions
Your agreements will remind you that these options don't give you any employment rights nor shareholder rights. People confuse holding stocks with holding stock options. So often this stuff is spelled out so that things are crystal clear. Again, be aware that just because you have an option doesn't mean you have shareholder rights.
The Stock Option Agreement will also limit your ability to give/sell someone your stock option.
Recommendations: Restrictions regarding the transfer of your options is normal. But make sure that the stock option can be transferable via Will or by the laws of descent and distribution (stuff that happens when you die.) This is a reasonable and should be included in your agreement.
11. Clawback/Repurchase Rights for Vested Shares
Some startups will include in the Stock Option Agreement that the startup can repurchase shares from you even if they have already vested to you in the case if you leave, do something detrimental towards the company, or compete. Usually these repurchase rights expire on the happening of an IPO or other major event.
There are a variety of different versions of this--from the startup being able to repurchase the shares from you at fair market value to the startup forcing you to pay the company back gains.
Recommendation: Avoid these.
These things can be called different names so be careful. Look carefully for what happens to your VESTED shares. Are the shares really yours? Before signing an employee contract with a company, look for this type of provision.
C. How much should you get when it comes to stock options
This is of course the million dollar (hopefully) question. There is no set answer to this question and there never will be because every situation and hiring is unique. These are only guidelines:
1. The larger the company, the less % of equity you will get
A larger company will have more established figures, more investors with equity, and the equity will carry more value. On the flipside, if you're going to work for a super tiny startup, you should expect a greater percentage of equity.
2. The more competitive your salary, the less equity you will get
If you are offered an awesome salary, the stock options may be more of a signing type of bonus or used for incentive purposes instead of for compensatory purposes. In this case your stock option grant will be smaller than otherwise.
3. It's all relative
There are no set numbers because too much depends on your position and capabilities, your location, the industry, and size of the company. Do the research, talk with people, and see what others are getting for the same type of position for a similarly sized company in the same geographic area.
Here in Houston, Texas and Dallas, Texas you will see different numbers than elsewhere. Every location is different.
4. Range of equity
For a company that has just done a Series A financing, here is the range of equity granted when the person is hired.
CEO: 5-8%
CTO: 2%-3%
COO: 2-4%
CFO: 1-2%
Board Member: 0.4-1.25
Lead Engineer: 0.5-1.5%
Senior Engineer:0.33-0.66
Junior Engineer: 0.2-0.33
The numbers in the aggregate should be about 20%. For an earlier stage company, there will be less hires and the numbers will be higher.
D. Exercising Your Stock Options
The exact method of exercising your stock options will be set out in the Stock Option Agreement/Exercise Agreement.
The biggest impediment to exercising your option is going to be timing issues.
Make sure your option has vested regarding the stock you want to purchase. Additionally, make sure you know the exercise timing is right. Look at the Stock Option Agreement and Exercise Agreement. Is there a lockout provision in place or other provision that keeps you from exercising at the present moment?
So read your stuff, know the timing issues, know what's required to exercise. When you go to purchase, know which option grant you will use, know the amount of shares you will be purchasing, and know how you will pay for these shares.
E. Stock Option Tax Issues
Yeah--this comes into play.
Why is there a tax on options?
There's a tax because options are a type of compensation. If you saved $20,000 off the fair market value when you exercised your options and bought some stock from the company, it is similar to the company giving you $20,000 in the form of pay. So you get taxed on it.
The tax consequences are different if the options were ISOs or NSOs.
Important note: you may have to pay taxes even if you don't receive any cash from the transaction. You can exercise an option and purchase shares, not receive any cash from doing so, and still have to pay taxes.
1. Nonqualified Stock Options Tax Consequences
Grant time
No tax consequences as long as the option was priced at the fair market value. If you do nothing with your option ever, there will be no tax consequences as well.
Vesting time
None as long as priced at fair market value.
Exercise time
Exercising the option for the shares you purchase will result in ordinary income tax consequences. The discount you get by purchasing the shares at the exercise price instead of the fair market value of the shares will be considered income to you. The amount of ordinary income will be (FMV - Exercise Price) x Number of shares actually purchased.
This amount is added to your ordinary income for the year even if you don't actually receive any cash from the transaction.
Selling time
You will have capital gains at the time of selling the stock. That capital gain will be considered short term or long term depending on the time that has passed since you exercised the stock (not from grant time.)
2. Incentive Stock Options Tax Consequences
Grant time
None as long as the option was priced at the fair market value.
Vesting time
None as long as priced at fair market value.
Exercise time
No ordinary income; no capital gains, but can trigger AMT (alternative minimum tax)
Selling time
Capital gains if held for 2 years from grant/1 year from exercise otherwise ordinary income--a "nondisqualifying disposition" . If not held for those periods, then ordinary income "disqualifying disposition."
F. Stock Option Tips and Takeaways
1. You will be getting options for common stock
That means it won't have anti-dilution protection and all of that other good stuff. Don't fret. It's the same stuff that founders, directors, others have. Your boss probably has the same type of stock you have. The preferred stock is for investors.
2. Plan for the timing of the exercise
Is there a good time for you to exercise your options? Consider deferring the exercise of your options to a time when the tax rate is low for you.
3. Make sure dates and timings are consistent
Cross check all the dates across your various agreements. Crappy cut and paste jobs make things difficult.
4. Watch out for clawback provisions
These are also called repurchase rights for vested shares and come in different forms. They can be harsh on option recipients and allow the company to buy back shares (even if they have vested) if the employee leaves or is terminated. Pay attention to these clauses if you see them in documents.
5. Read in conjunction the stock option plan and other documents
There will be information that you believe should be in the Stock Option Agreement that's not in there and is instead in the Stock Option Plan. Read and KEEP both documents.
6. Know when you can exercise your options
Just because your shares have vested doesn't mean that you can exercise your options. Watch out for timing issues.
7. Don't try to negotiate the exercise price
The exercise price should be set to FMV at the time of grant. If it's below or above the FMV, there will be tax consequences and other complications. Keep things simple. There's a reason why the company set the exercise price at the FMV.
G. Stock Options for Employees Conclusion
And that's pretty much it. If you have some questions--shoot me an email and let's talk.