MaRS Library Employee stock options: A compensation strategy for your startup
Stock options plans have long been a common part of an executive’s compensation package, but these plans can be offered to other employees as well. Stock options can effectively engage employees in the longer term and create a sense of ownership.
Most employee stock option programs are cashless. This means the employee is not required to pay for the options when they are issued, and are eligible only to receive the difference between the issue price and the exercise price when exercised.
Stock option plans and vesting schedules
Options can generally be exercised (or “sold”) at any time during an agreed-upon term, subject to a vesting schedule. Vesting schedules outline the percentage of options that are allowed to be exercised after a given amount of time. Vesting schedules among smaller companies generally extend for three or four years, vesting on a prorated basis monthly, quarterly or annually.
Example: Stock option plan vesting schedule
As part of his compensation strategy, Josh is given 5,000 employee stock options when he joins the startup. The options are currently valued at $1.00 each, and vest quarterly over a four-year period. The stock options also have an expiry date, which is the date by which all the options must be exercised or they will be forfeit.
Josh is eligible to exercise his options at a rate of 312.5 options every three months. In other words, every three months 312.5 more options become available to him, until all 5,000 have become available over the four years from the date of issue.
|Timing||Number of options vested||Issue price||Exercise price||Does Josh hold or exercise?||Josh gets…|
|After one year||1,250||$1.00||$1.25||Hold||$0|
|After two years||2,500||$1.00||$2.00||Exercise||$2,500= ($2.00 -$1.00) × 2,500|
|After three Years||1,250= 3,750 – 2,500 exercised||$1.00||$2.50||Hold||$0|
|After four years||2,500= 5,000 – 2,500 exercised||$1.00||$3.00||Exercise||$5,000= ($3.00 -$1.00) × 2,500|
Plan your startup’s employee stock option pool carefully
It is common that all employees are eligible for stock options in smaller organizations, and about 70% of employees actually receive them. The biggest challenge many startups face with employee stock option plans is that if the plans are not carefully structured and managed for the longer term, the allocation of options can reduce the availability of options for new hires as the organization grows.
While it is generally possible to award significant options to early-stage employees, it can become increasingly difficult to continue at the same level as the organization grows. This occurs because the stock option pool diminishes every time the company awards options, and if the plan is not well organized, the options may run out.
The size of the employee stock option pool is determined by shareholders. Once it is set, it is not easily increased later as this dilutes the value of existing options, which is generally not favoured by shareholders. Whenever a business implements a stock option plan, both legal and financial counsel is required.
Employee stock options: An incentive in your compensation package
While stock options are commonly offered when employees are hired, they can also be used to recognize critical talent, top performers and job promotions. As part of their compensation strategy, some organizations also offer smaller, annual option grants.