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How can I understand startup stock and options and how they are different in layman’s terms?

I appreciate your confusion as this stuff can get confusing! Here’s a breakdown.

Equity can mean stock (or shares), although it’s often used to refer to stock options as well. Think of equity as the umbrella term that means an ownership interest whether expressed as stock or not. Shares are one expression of equity, but not the only kind since you can own equity in a non-corporate business or investment property.

Stock is a type of equity that’s commonly referred to as an equity investment. When you buy stock as an equity investment, you’re expecting its value to increase and to derive income from its dividends or the profit you make from its sale (capital gains).

Stock options give you the right to buy a certain number of shares at a certain price after a certain amount of time. They do not represent ownership, however, unless your right to buy them has vested. Until then, there’s no equity.

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.

LawTrades was created to provide bootstrapped startups with affordable help from high quality lawyers about all-things-startup: stock issues, stock options, funding rounds and related ownership structuring. Feel free to check them out or PM me directly with your questions about equity and ownership.

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