An option is a privilege, sold by one party to another, which gives the buyer (the option holder) the right, but not the obligation, to buy or sell a stock at an agreed-upon price (i.e. the set or strike price) within a certain period or on a specific date. In the world of startups options are typically offered to employees as part of their compensation package. That option gives the employee the opportunity to purchase stock at a price lower than the market value of that stock. However, employees must typically wait a specified vesting period before being allowed to exercise (or buy) the option.
One benefit of a stock option from a startup’s perspective, as opposed to another form of employee equity, is that a stock option is only valuable if the stock increases in value. Thus, by incentivizing increased stock price, stock options attempt to align the goals of the founders/current stockholders and new employees. For example, if an employee was given an option for 10,000 shares with a strike price of $1 and after a four year vesting period the shares are worth $10 exercising the option nets the employee $90,000. The better the stock performs the more valuable the option becomes to the employee. This is a win/win for the startup and the employee.
Furthermore, the issuance of options by the startup is often a simple exercise without significant administrative burdens. This lack of administrative barriers, makes options a great avenue to help your startup retain successful and talented employees who might not otherwise be interested without the promise of additional compensation down the road. In addition, most carefully crafted stock option plans allow the stock option to be exercised without the employee paying out of pocket. Thus, this is often an effective and affordable form of compensation for startups.
Another valuable characteristic of options is that they don’t typically burden an employee with immediate income tax liability. Typically, options are taxable upon exercise. In contrast, the issuance of shares of stock to an employee is a taxable event to the employee. This potential tax liability could disincentives prospective employees from joining a startup.
To ensure options are not immediately taxable to employees, it is strongly suggested that your startup undergo a 409 valuation. “409” is reference to the Section 409A of the Internal Revenue Code. Failure to abide by this provision has significant penalties for the employee and startup. In sum, this valuation assists a startup with setting the strike price for their employee stock options, which needs to be at or above fair market value.
The attorneys at Moisan Legal, P.C. are ready to help your startup offer employee stock option compensation packages that make sense to you and your employees so that you can focus on what truly matters, growing your business.