Preparing employee stock option agreements is a complex and lengthy process. This is why we decided to…
Employee Stock Options: Common Practices And Examples
In our previous post about how much equity to offer to investors at different funding rounds, we looked at the equity boundaries that a founder can offer at the different stages of development of a startup.
However, there is also the case of rewarding early employees with stock options. In our experience, there is no one-size-fits-all solution when it comes to assigning employee stock options but there are some similarities and terms you need to be aware of.
What is a stock option?
First of all, you need to keep in mind that stock options are nothing else than a contract. So the terms discussed here are nothing else than the terms of a contract only they are adjusted to the case, to the type of company and to the type of employee. You usually have a very high degree of customization. But what you cannot customize is the way an option works.
A stock option functions in the following way: you assign the right to a person- the holder, to buy a certain underlying asset – in this case the shares in your company, at a price that you decide today.
The bet for the holder of the option is that the price of the asset tomorrow is going to be higher than the price of the option.
Terms in a stock option agreement
1| Who to entitle with stock options
This really depends on the culture of the company and the choice of who you want to entitle with stock options will also determine the terms of this contract. The common practice is to reward with stock options early employees – say the first up to 10 employees beyond the founders. The reason is that they are like founders or they have been working as founders so you want to make sure that you keep them throughout the life of your startup.
In Uber it’s kind of common practice to give options to everybody but they also give very strict terms to convert the option.
2|What percentage to give
There is no common rule for this. It really depends on the person that is getting the options. For some ideas you can also look at Angel list. There are some offers for developers with stock options equity ranging from 2% to 10% of the equity. Keep in mind that whatever the percentage is, it needs to be converted in the number of shares at the moment in which the option is issued.
This is very important because percentages are relative and the number of shares is nominal- fixed. So if you issue the option today it’s going to have a fixed number of shares. This means that the holder of that option, so the potential buyer of the shares, is also subject to future dilution just like any investors that would invest today for the same number of options.
3| The type of shares
It is not recommended that the shares that you give away are preferred shares. So it is best for this purpose to use the junior level shares – common shares, or even a level below – no voting shares. It is also common to create an option pool, which means that you reserve a number of shares for any stock holder in the future. This is the case of a foundation. Usually, the employee would own certificates of shares for the foundation and not directly to the company. The employee is thus entitled to the economic rights, without having an impact on business decisions.
4| Strike price
You need to decide at which price the holder can exercise the option. Usually, this is something that the board of directors determines. Generally, you should rely on the fair market value of the company at the time of which the stock option is issued.
5| Vesting schedule & Cliff
Vesting schedule means that the right to exercise the number of options will accrue over time. The average duration for this period is 4 years. The cliff is a period, a threshold, before which if the option holder leaves the company, he/she loses the right to the option. Usually, the cliff is 1 year.
You also need to decide on the type of vesting schedule and the vesting unit. Linear vesting schedule means that then shares accrue every month the same. Non-linear, i.e. the back-end loaded stock vesting that Snapchat is using, means that every year there is a different percentage of the stocks that vests. So in the case of Snapchat, the first year 10% of the shares vest, 20% in the second, 30% in the third and 40% in the fourth year. This way of compensation increases the incentive for the employee to stay with the company even beyond the cliff.
6| Exercise date & exercise period
After the vesting period, the option can be exercised. It cannot, however, be exercised forever. In any option contract, the holder is expected to pay the strike price cash. If you extend the exercise period, you give a chance to the employee to wait for an exit. For instance, at the exercise date the employee has to pay for the shares in cash, let’s take 10$ per share. In case the exercise period is longer, at the time of the exit the employee is entitled to say 20$ per share. In this case, the employee has to pay 10$ because of the option and receive 20$ because of the exit. Therefore, he/she will receive the net value of 10$.
Bear in mind that in some geographies the employee might be required to pay taxes on the capital gain of the stock option. It is country-specific, so it is advisable that you look it up beforehand.
For the founders might be useful to know that you can protect your company against the so-called bad leavers. The definition of a bad leaver is very broad, basically depends on what you include in your agreement. When the employee is a bad leaver – someone who exploits the contract for their own malicious purposes, you are protected by the law. You can also include certain terms in the agreement that further protect you from bad leavers.
Check out our FREE employee stock options template!