• October 2019
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How do Stock Options Work?

Stock options make the most economical sense for larger startups with a relatively developed staff (senior management, rank-and-file, etc.). Since creating an options program is time intensive and requires highly specialized legal expertise, they’re quite costly to implement. Therefore, creating a stock options program for just one employee doesn’t justify the cost.

Here’s how options work: your company offers you the right to buy a certain number of shares at a certain price (the strike price) at a certain time after you’ve earned the right to exercise (buy) your options. Your earn the right to exercise your options (buy the company’s stock at the strike price) after the vesting period, which is typically four years, with a one year cliff. This means that if you leave before the end of the first year, you get nothing; if you continue to be employed with the company after the first year, you get 25% after your first year anniversary and 25% each year until fully vested after four years.

Employees offered options aren’t obligated to purchase company stock; they simply have the option to buy or not. If the stock is valued above the strike price at the time of exercise, then the the employee can buy it, making a profit when it’s sold; conversely, stock valued below strike price at the time of exercise will be worthless. For example, if my options contract allows me to buy the stock at $10/share, and is selling at $15/share on the day I exercise my options (after the vesting period), I can buy it for $10/share, sell it for $15/share, and realize a $5/share gain on which I’ll pay taxes only when I sell. On the other hand, if the stock is valued at $9/share at the time I can exercise my options, I’m looking at worthless stock and walking away.

Also, there are different types of stock options with varying tax consequences – e.g., incentive stock options (ISOs) and non-qualified options. Seeking professional guidance is always recommended.

While the purpose of offering employees stock options is to encourage loyalty and promote their longevity with the company, other avenues of motivation might be more appropriate for the smaller startup. These include a wide range of incentives such as flex time, generous vacation/personal time, paid gym/yoga memberships, continuing education, work from home opportunities and bonuses. The list is practically endless, but as you can see, more appropriate for a smaller startup.

If you need further guidance regarding issuing stock options, check out LawTrades.