Compensation of employees can take many forms: Usually, salaries form the basis, with additional benefits added on top. For startups with less liquidity at hand or companies searching for ways to incentivize employees taking ownership and staying for the long term to build and grow the business, there are alternative options to attract and retain talent: Stock options. If you have worked for a tech company, especially in the US, you will most likely have come across equity in the form of stock options.
If you're interested in why companies issue equity and how exactly stock options work, this one is for you. Let's start with stock options, then step back and think about why sharing ownership of a company has become more popular around the world and the norm in Silicon Valley.
Options are not shares, but represent the option to purchase a specific amount of shares, so ownership in the company, at a greatly reduced price, the strike price, which the employee must pay for each share. Buying these shares is referred to as exercising the option.
You might wonder why companies don't issue shares directly. In some countries, employees receiving shares would be required to pay a premium or tax when they receive the shares. Stock options, in contrast, only become subject to taxes when exercised by the employee.
While we will focus mostly on stock options in this post, in some countries, bureaucracy and tax burden lead to companies adopting conceptually similar but technically different methods of sharing equity, such as virtual stock options or shares, which mirror economic benefits but do not represent ownership in the same way, as they are technically employee benefits. Usually, leavers forfeit rights to virtual options completely under these agreements. In addition to virtual stock options, there are other instruments including Restricted stock units (RSUs), which promise the holder to receive common stock at zero cost in the future.
Reasons for Sharing Equity
As stock options can be used to purchase shares and thus material ownership in a company, granting options creates an incentive for employees to increase the value of a company by putting in more effort. It also helps to build a culture of ownership, as everyone is ultimately in the same boat, ensuring the company's long-term success.
Granting stock options does not mean equity, so ownership of a company is made available to employees immediately. When you hire a new team member, you want to be sure they don't leave early, taking their ownership with them. Instead, equity is "vested" over time, becoming gradually available to employees the longer they work for your company.
For this reason, companies create a vesting schedule: Usually, a cliff of one year ensures employees leaving within their first year are not eligible for stock options. After the cliff, employees receive 25% of their granted options, then the next 25% after another year, until 100% are reached after four years. The vesting duration depends on the hours employees work, in theory, switching to part-time will increase the time it takes for all options to become available.
While four years of vesting duration with a linear increase of shares over time is the usual approach, there are alternatives such as back-loaded vesting, where an increasing amount of shares are granted over time, so employees stay with the company for a longer period.
Stripe and Lyft recently adopted a vesting schedule of one year, which removes the employees' obligation to stay for a long time to reach full compensation and exercise their options.
Employees Leaving the Company
If an employee leaves with some or all of their options vested, it can make sense to split up in good terms and facilitate leavers to exercise their stock options. Typically, employees who leave have 90 days to exercise their options, after which any remaining options are forfeited. As the strike price may be substantial, employees need to decide quickly if they want to acquire shares that may be uncertain in their outcome, as it might take years until the company exits and the shares can be sold.
In Europe, high strike prices, as well as legal and tax burdens often lead to companies allowing their employees to retain their vested options after leaving.
As option grants are agreed upon in regular contracts, part of ESOP (Employee Stock Option Plan) or similar, it is important to get all details right, as any change may become expensive. Choices such as the strike price depend on the country your company operates in, Germany, for example, you usually use the pricing of the latest funding round to avoid additional taxes.
The importance of dilution
As with any other share in the company, shares acquired through stock options are subject to dilution: When the volume of issued shares increases, the relative amount of each shareholder may decrease if not adjusted for the new total, a process venture capital investors manage through pro-rata clauses, which gives them the right, but not the obligation, to participate in future investments, keeping their percentage stake in the company constant, and thus potentially retaining a board seat as the company grows.
For regular employees, though, this means that the share of ownership will decrease over time as the company raises more funds, which does not take into account valuation increases: Even though you might own a smaller stake of the company, it may still be worth more.
It is important to know that shares come in multiple classes, common shares for founders, employees, and early investors, as well as preference or preferred shares. If the company is sold at a lower amount than its valuation, entities holding preferred shares get their money back first, followed by common shareholders. This reduces risk for investors while potentially leading to no returns for founders and other shareholders.
The right amount of equity
Now that we know how granting ownership in the form of stock options can help acquire and retain motivated employees, how much equity should you offer to new hires or as a performance bonus? Usually, it depends on the role and experience: While senior engineering hires are usually granted up to 1% of a company, mid-level employees receive around 0.5%, and entry-level or junior hires are granted 0.2% equity. While other departments such as product design are similar, community, marketing, and business development hires usually receive less equity. Advisors to the company tend to receive 0.2%. Note that it is much more common to calculate option grants as a percentage of the base salary of an employee, which makes it easy to estimate in terms of cash.
Of course, these numbers are just what investors and companies report but your mileage may vary: When making a hire is critical for your business development, you might allocate more equity than what I outlined above, and it might be completely reasonable if the competition is strong.
Communication is key
Another important factor for sharing equity with employees is communication: Not every employee might completely understand how vesting schemes and stock options work, when they can exercise their options, and if granting stock options also bears risk.
For these reasons, you should clearly state that holding stock options does not cost anything if not exercised, that there is no risk associated and that their options may translate into a cash bonus in the future. Do not set false expectations about the (future) value of an employee's equity or create a sense of secrecy when it comes to how the company's capital structure is set up.
A typical dilemma of sharing equity is that earlier employees get a higher stake in the company, compared to the people joining later down the road, even if their work might be more valuable.
Then there's the question of when to offer option grants, usually, companies should only do so if there are compelling reasons, as this makes it easier to find out who the high performers are and compensate them later on. As you will know a lot more about a new hire after a year or two have passed, you can optimize their options grant to their performance.
By now, you might think about giving all employees a small options grant, which is a great signal for new hires that they are valued and important in the future development of the company. For this reason, authorizing a high share capital (i.e. raising the total individual shares the company can issue) allows you to be more precise with option grants.
There's much more to learn on how to create and scale employee stock option plans (ESOP) over time, but I wanted to focus on the most important details in this post, both for founders and employees.
If you're interested in more resources on the topic, I can recommend the following reads
- Rewarding Talent by Index Ventures
- Founder's guide for equity by Patrick McKenzie at Stripe Atlas
- How to Make Startup Stock Options a Better Deal for Employees in Harvard Business Review