Ever heard of David Choe?
He’s a graffiti artist who was commissioned to paint some murals in Facebook’s first offices, and was paid in options. When Facebook went public seven years later, those options were worth $200 million.
You’ve likely heard stories of early employees of startups becoming wealthy via options—and that can include contractors like David Choe.
Early-stage technology companies are always looking for ways to conserve cash while attracting great talent to build and scale their companies. Early on it’s difficult to pay market salaries for great talent so startups rely on options to provide future incentive to important hires.
Stock-based compensation – one form being options – are a tool commonly used to reduce the cash cost of employees early in a startup’s life. These options have benefits for both the company and the employee, and create a relationship that aligns the founders and employees with the goal of providing long-term incentives.
How it works
Options are typically given to new key hires as part of their long-term incentive plan. The options will likely come with a vesting period, usually 3 to 4 years, meaning the employee’s options will vest over that period. The option holder can usually hold the options for up to 7 years before deciding if they want to exercise them, meaning converting them to stock in the company. If the company is sold during this period, there’s usually a clause that all options immediately vest and the option-holder can exercise them prior to the sale closing, as new owners typically don’t want the overhang of option holders.
An employee stock option plan, or ESOP for short, gives the option-holder a future right to acquire those options, once vested, at a pre-agreed strike price and convert them to shares in the company.
So, for example, if you were offered 100,000 options vesting over three years at a strike price of $.10/share, and the company sells for $1.00 per share in the future, your options have a networth to you of $90,000.
Stock options plans can range between 10% and 15% of a company’s total stock. It’s important for the option-holder to know exactly how many shares are outstanding, the share price, and how many options have been granted before agreeing to options as part of their compensation.
Offering options has a number of benefits for your company. Aside from the obvious benefit of conserving cash by paying a lower salary, they encourage employee retention. Because the options vest over three or four years, employees are committed for that length of time before they can become owners in the company. Even after their shares have vested, employees tend to stay and wait for a liquidity event; if they leave before, they must convert the vested options into shares within a short window, (usually 30 days) which is an out-of-pocket expense that the average employee may not be able to fund.
And if departing employees don’t exercise their options, meaning when employees leave the company—even after their options have vested—those options are returned to the option pool.
Companies should be consistent with stock-based compensation and give options rather than equity to early hires; I’ve seen startups give equity early on, which can be a big mistake. If an employee departs and holds equity, you end up with shareholders on your cap table who aren’t helping you grow the business. Options give you the ability to confirm value add over time before allowing employees to become shareholders.
More than anything else, option-holders are being given a right to participate in the upside value creation of the company; if the company increases its valuation, the option value also increases. Options give holders the right to become a shareholder (assuming they vest), which brings a sense of ownership, engagement, and hopefully work satisfaction.
Be sure to explain how options work to your employees, and know the ins and outs of options yourself. For example, remember that when an employee accepts options when hired, it isn’t a taxable transaction, but if you give equity to a new hire, that is a taxable transaction. Many potential hires won’t know the intricacies of options and what value they bring, so give them the run-down.
For an even more detailed account of how options work, check out this piece by VC firm Andreessen Horowitz.