Should I issue share options in my startup?

They say there are two sides to every story, and this is definitely true when it comes to using options and equity as incentives in the early stages of a company. Your perspective on options depends very much on whether you are the employee being asked to sacrifice some of your salary, or if you’re a founder "giving away" a portion of your company before you have any idea what it might be worth.

As an employee, you might have heard of the story of the Google chef who was given options when he started work there in 1999, only for it to become worth tens of millions of dollars. Then there's the artist who painted a mural for Facebook. He took stock options instead of cash for his fee, somewhat reluctantly, but when Facebook completed its IPO in 2012, the options were worth $200m. Of course, these are exceptions. More often than not, those stock options you took in exchange for a decent salary never turn into the millions you had hoped for.

Options versus equity

As a quick explainer, there are clear differences between options and equity. Equity is straightforward. If you receive shares, quite simply, you own a portion of the company. In all likelihood you will be bound by a legal document called the "shareholders agreement", and you probably can’t sell until the company goes public or the founders sell the company. Even then you may be locked in for a certain period. Options, on the other hand, give you an “option” to buy a share at a certain price (called the "strike price"), once that option has "vested".

An employee’s options will usually vest over time. For example, the company might grant you 100,000 options at a strike price of $0.10 over 4 years. This means that, at end of each year, you will be entitled to receive 25% of your shares, provided you pay the strike price (thus "exercising" the options), which in this case would be $2,500. If the company is publicly listed and the share price is higher than $0.10 then it’s a no-brainer. You buy them in the same instance as selling them, meaning you never have to cough up any cash. But if the startup you work for is still privately held then you have no way of knowing what your shares are actually worth. You could pay the strike price, only for the company to fail and the shares to be worthless. Alternatively, you might want to leave the company. In that case, you will lose any options that have not yet vested and may need either to pay for those that have, or to give them up.

Do I give early employees a share of my business right away?

As a founder, it will be up to you to decide how you want your options to function, or whether you wish to grant them at all. Can you achieve the same thing by offering employees a profit share? If you're a startup, it's likely that there will be no profit for some years to come, so granting share options may be your only alternative to paying competitive salaries.

If possible, it's usually best to grant share options over time. The later you can issue them, the more each option will be worth and the fewer options you'll need to distribute. This can help minimise the dilution of your company's shares, while still ensuring your employees are well rewarded. It can also help avoid situations where founders regret giving too much away at the start of the journey.

It's not uncommon for early employees to have a disproportionately large stake in a business versus their peers who joined later. It's not wrong for those early risk takers to own more, but it's important to get the balance right. You don't want friction between employees. Remember, as your company grows in size and reputation, you may be able to attract better people. You'll want to keep some options aside, so that you can retain those rockstar people too, not just your first hires.

The right way to issue options

Done right, options can be a great way for founders to incentivise and retain staff. Schemes can be set up in such a way that it is in employees’ interests to stay with the company and not to look for another job. This can be crucial, especially in the tech world, where competition for talent is fierce.

Many founders, of course, also believe it is fair to give back some of the wealth that their employees helped to create. They should also, wherever possible, ensure it's never the right time for their employees to leave. If a key person's last remaining options are vesting, it's important to be able to grant more, with no lengthy "cliff" (a lock-up period in which options accrue but don't vest), in order to keep sweetening the pot. Distributing options gradually in this way ensures the employee never reaches a point at which it is logical and painless to move on. (There's an excellent article here explaining how to do just that.)

Communicating your options scheme

Most startup founders believe that giving away options is a fair way of rewarding loyalty, but it's also important to explain how the options work. The challenge is in making sure that the employees understand the value of those options and continue to feel that it is worth their time and effort to stay with the startup. This doesn't mean issuing a 30-page legal policy, which governs how the options work. It means being transparent, being willing to answer questions, and being clear about your specific process, especially around vesting and exercising.

Founders may also wish to include options holders in their investor updates and shareholder communications, so that employees understand what they own a piece of. Most startups lack common benefits, like health insurance and pension contributions, which larger companies tend to offer. The value of options must therefore be made clear if they're to serve the purpose of inspiring loyalty. This is particularly true in earlier-stage startups, that can lack even basic structure around career paths and promotion.

Why are options potentially so risky to employees?

Put yourself in the shoes of this employee:

You join a company on the promise of, say, 1% of the company in options. You later resign, having vested 0.5% (50% of what you'd have got had you lasted for the whole vesting period). At that point, because you're leaving, the company needs you to exercise your options.

There are two problems:

1. Your vested options, while being worth $150K on paper, have no market and no liquidity. In order to exercise them, you need to pay for them. As a result of the strike price in your options agreement, you need to pay $30,000 to buy the options. On paper, that's a great investment - you're 500% up the moment you buy them. However, while you're sitting on a potential gain of $120K, there's no market for your shares, so you can't sell them. Nor is there any guarantee the company will make it. Taking that into account, the $30K it's going to cost you to exercise your options feels like an awfully big risk to take.

2. It gets worse. Because you exercise the options, you have to pay tax on them. Exercising options is a taxable activity, so if the strike price is lower than the current valuation, you owe taxes on the “gain”, even if it’s not realised!!! So suddenly you owe a LOT more than $30K, for shares in a company you're walking away from.

How do I create an options scheme that's fair for my employees?

Looking at the situation above, it's no surprise that many employees simply give up their options and leave the startups they've devoted years of their lives to with nothing. In such cases, the unexercised options go back into the options pool. The company can then issue them to someone else, or they can be written off, leaving the rest of the shareholders with a greater share of the pot. Meanwhile you, as the employee, leave your job severely out of pocket. Having worked for 2 years for a salary that was, maybe, half your market value, you have nothing to show for it. It's no surprise you feel disenfranchised with the whole startup world.

This isn't how options are supposed to work. Founders need to ask themselves:

Is my options scheme about sharing the wealth, offering fair reward to the people who are helping me generate value, while attracting talent that otherwise I couldn't possibly afford? Or is it about getting the best possible people at the lowest possible price?

Option schemes can do either. It's certainly possible to grant options to employees, while at the same time making those options very hard to come by. As in the example above, short "post-termination exercise periods" can force employees into a decision on their vested options. Do they take a risk and purchase them, despite being uncertain about their future value? Or do they avoid the risk of losing their cash and walk away from what could potentially be a big payout.

In our view, startup employees should never have to make such a decision. After all, these people have already taken a risk by joining you in the first place. Fortunately longer, or even indefinite, exercise periods are becoming more common, meaning employees can keep what they've vested without having to put cash on the line when they resign.

If you're a startup founder, make sure you understand the implications of the way your options scheme is designed. There's no reason it can't work for everybody - rewarding employees, while helping you hire - and retain - great people, without paying full market rate.

When Google went public in 2004, thanks to its options scheme, over 900 employees became millionaires (including the chef!). There are, of course, thousands of employees who took share options in companies that never made it, but by being fair with your options, you can be sure that, if you hit a home run, the people who helped you get there will enjoy it with you.

Further reading

You can find more technical information about the workings of options schemes in these excellent articles:

• The right way to grant equity to your employees
• A no BS guide to startup stock option grants
• Equity basics for founders

Image credits

– Featured image by Vladislav Babienko on Unsplash