Stock vs Stock Options for Startups: What to Issue & When
When to issue stock vs options
TLDR:
Stock = ownership issued today.
Stock options = the right to buy stock later at a fixed “strike” price.
Early on, stock is cheap and simple; as the company grows and the share price rises, options become the practical way to give employees upside without upfront cash or immediate taxes.
Important: This article simplifies concepts for explanation. It is not tax or legal advice.
Stock vs Options
You have your entity setup as a corporation and now you want to issue shares to your first employees. However, you have heard about these things called stock options. They are popular in the startup world. In fact, there’s a rumor that the guy who did paint work at Facebook was paid in stock options and became a millionaire when he cashed out years later (he was actually paid in stock). Now you are wondering whether you should issue options to your employees instead of shares. However, you are wondering what stock options are and why you should use them. Let’s get into it. In this article, we will discuss what stock options are and when you should use. Let’s begin with what stock is.
Stock Defined
Stock (or shares) is evidence of ownership in a company. If you buy shares, you own a piece of the company. The percentage you own is defined by how much of the total shares of the company you bought. Its that simple. There are different kinds of shares. But at the end of the day, they define ownership in a company.
Stock Options Defined
Stock Options however are not ownership in the company. Stock options are what they sound like; they are the option to buy stock of the company. Now, why would someone want the option to buy stock instead of buying stock directly now or in the future when they are ready.
There are few reasons. The first is that the person is not ready to purchase the shares now. However, the price of stock tends to rise. So, the person would like to lock in the price of the shares today so that it remains cheap when they are ready to purchase. For publicly traded companies, buyers pay for this privilege. For private companies, however, these are granted to employees without charge.
Why startups use stock options
Which brings us to why they are used in startups. At a certain stage when a startup has grown and has real value, either due to VC investment, incoming revenue, patents, or more, the price of its shares goes up. It can cost tens or hundreds of thousands of dollars to acquire shares at some point. Many employees will not have the funds to pay for that. Even if you grant them as awards, they may not be able to afford the taxes they will have to pay on those shares, since they will be taxed as compensation (usually as they vest). They are too expensive for the average employee.
You may wonder how stock options are better. After all, stock options simply lock in the present price of the stock. If it’s too expensive for the employee now. It may still be too expensive for them in the future. With options you are gambling that the value of the stock will continue to rise and the employee can take advantage of that. When you issue the options, the employee does not have to pay for them in cash today. Therefore, it costs them nothing today. They don’t need to pay for the stock or pay taxes on them, because they do not own them. They only own the option to purchase the stock in the future.
In the future, usually when the company is about to go public or get acquired, the employee can exercise the stock options. As to the problem of exercising the options. They have a few options. They can arrange with the Company to pay for the shares with the shares. Like stated earlier, the value of the underlying shares should have increased since the stock options were issued. The price of the underlying shares were however already locked in when the options were granted. Therefore, the employee only pays the lower price. In that case, they can use some of the shares, based on the higher value of the shares today, to pay for the rest of the shares. If the price of the shares totals $10,000 for instance but the value of the shares is $100,000. They can ask the company to take $10,000 worth of shares and only issue them the remaining $90,000 worth. In some cases, external firms may be willing to front the employee the money to purchase the shares, to be paid back when the employee sells the shares.
When to use stock vs stock options
By this time, you should have figured it out. Issue stock options when the value of your stock becomes too expensive for the average employee to afford. When your company is formed, the value of your stock is almost nothing. In most certificates of incorporation for a new company, the value is set at $0.001 or other de minimis amount. Here, the employee can afford to pay for the stock (if they are a founder) or get the stock for free but pay taxes on it (if they are an early employee). If the stock appreciates later, they pay capital gains taxes when they sell the stock. However, once the company begins to grow – generally towards your Series A – stock options become a good idea. Your employees will not need to shell out large amounts to pay for stock. They can hold the stock options until an exit event or such a time as they may otherwise need to exercise it.
Conclusion
We go more into stock options in another article. However, in summary, you will want to issue stock options when your company becomes so valuable that the average employee cannot afford to pay for stock. This typically happens towards the Series A equity funding.
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