There are a few different types of compensation packages that are typical for startups.
The most common is equity-based compensation, which means that employees are given a certain amount of equity in the company. This can be in the form of stock options, restricted stock, or even just regular common stock.
Equity-based compensation gives employees a vested interest in the success of the company and can be a powerful motivator.
Another common type of compensation for startups is cash-based compensation. This includes things like salary, bonuses, and other forms of cash payments.
Cash-based compensation is less common in startups than equity-based compensation, but it can still be used to attract and retain top talent.
Finally, some startups also offer benefits-based compensation, which can include things like health insurance, retirement plans, and other perks.
Benefits-based compensation is less common than equity- or cash-based compensation, but it can be a valuable addition to a startup’s total compensation package.
Today, we’ll focus more on equity-based compensation, stock options.
Stock Options and Startups
Stock options are a key part of many startup compensation packages.
But what exactly are they? How do they work? And how can you make sure your startup is offering them in the most advantageous way?
What are Stock Options?
Simply put, stock options are the right to purchase shares of a company at a set price, known as the strike price. The strike price is usually set at the time the options are granted, and it is typically the fair market value of the shares at that time.
The key word here is “right.” With stock options, you are not actually purchasing shares of the company at the strike price. Instead, you are given the right to purchase shares at that price.
There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs can only be granted to employees, and they come with a few special tax benefits that we’ll discuss later. NSOs can be granted to anyone, including employees, contractors, and investors.
How do Stock Options Work?
Now that we know what stock options are, let’s take a look at how they work.
When you’re granted stock options, you’re given the right to purchase shares of the company at the strike price. But you don’t have to exercise that right immediately. In most cases, you can wait until the stock price reaches a certain point that you think is favorable, and then exercise your options.
This waiting period is known as the vesting period. The vesting period is the amount of time that you have to wait before you can exercise your options. It’s typically set at four years, but it can be shorter or longer, depending on the company.
Once the vesting period is over, you have a limited amount of time to exercise your options. This is known as the exercise period, and it’s usually 10 years.
If you don’t exercise your options during the exercise period, they will expire and you will forfeit them.
If you do exercise your options, you will purchase shares of the company at the strike price. You can then hold on to those shares or sell them right away.
What are the Benefits of Stock Options?
There are a few key benefits that come with having stock options.
First, stock options can give you the opportunity to purchase shares of the company at a discount. If the company’s stock price increases after you exercise your options, you’ll be able to sell your shares for a profit.
Second, stock options can provide you with a way to diversify your investment portfolio. If you’re heavily invested in one company, owning stock options in that company can help to reduce your risk.
Third, stock options can give you a sense of ownership in the company. If you believe in the company’s long-term prospects, owning stock options can be a way to make money while also supporting the company’s success.
Fourth, stock options can serve as a form of incentive compensation. If you’re given stock options as part of your compensation package, it can be a powerful motivator to help you achieve your goals.
Fifth, stock options can give you liquidity in the event that you need to sell your shares. If you own shares outright, you may have to wait for a buyer. But if you have stock options, you can exercise your options and then immediately sell your shares.
What are the Risks of Stock Options?
There are also a few risks that come with having stock options.
First, if the company’s stock price doesn’t increase after you exercise your options, you’ll be stuck with shares that are worth less than the strike price.
Second, if the company’s stock price falls after you exercise your options, you could lose money.
Third, if you don’t exercise your options before they expire, you’ll forfeit them and you won’t get anything for them.
Fourth, if the company goes bankrupt, you could lose your entire investment.
Finally, stock options can be complex and confusing. If you don’t understand how they work, you could make some costly mistakes.
Should you Invest in Stock Options?
As with any investment, there are risks and rewards associated with stock options. You’ll need to weigh the potential benefits and risks before deciding if stock options are right for you.
If you’re considering investing in stock options, be sure to do your research and consult with a financial advisor to help you make the best decision.
Should Stock Options be a Part of a Startup’s Compensation package?
One of the most common questions we get from startups is whether or not they should offer stock options to their employees.
The answer is: it depends.
There are a few things you need to take into account, such as the stage of your startup, your financial situation, and the types of employees you’re looking to attract.
If you’re an early-stage startup, stock options can be a great way to attract and retain top talent. However, if you’re not careful, they can also be a huge drain on your finances.
Here are a few things to keep in mind if you’re considering offering stock options to your employees:
The Stage of Your Startup
If you’re an early-stage startup, stock options can be a great way to attract and retain top talent. However, if you’re not careful, they can also be a huge drain on your finances.
Your Financial Situation
Stock options can be expensive, so make sure you have the financial resources to support them before you make any commitments.
The Types of Employees You’re Looking to Attract
Stock options are often most attractive to employees who are looking for long-term stability and potential upside. If you’re primarily looking for short-term help, they may not be the best option.
The Tax Implications
There are a number of tax implications to consider when offering stock options, so make sure you understand the potential consequences before moving forward.
The Impact on Your Equity
Giving out stock options will dilute your ownership stake in the company, so make sure you’re comfortable with that before making any decisions.
If you’re still not sure whether or not stock options are right for your startup, we suggest talking to a qualified accountant or attorney who can help you weigh the pros and cons.