Updated July 8, 2020:

Offering start-up stock options is a great way to attract and retain employees for your company. As the company grows and becomes more successful, these stock options can be exercised and be very lucrative with little cost to the company.

How Employee Stock Options Work in Start-Up Companies

A stock option plan is a very popular way of motivating, attracting, and retaining staff, particularly for companies that cannot pay higher wages. A stock option plan will give the company the opportunity to award stock to employees, directors, officers, consultants, and advisors. This lets them purchase stock in the company when they choose to exercise this option.

They allow employees to share the company’s successes while not requiring the business to spend additional money. This is especially important for start-ups since there is not as much cash as there is in an established business.

Stock option plans help to contribute money to a company because the employees will pay the exercise price.

The disadvantage of stock option plans for a company is that it can possibly dilute the equity of other shareholders once employees exercise their options. A disadvantage for the employees is that there is a lack of liquidity in a private company as compared to higher compensation or cash bonuses.

The options will not be equal to cash benefits until the company creates or acquires a public market for the stock. If the company doesn’t grow larger, the stock will not gain value and will be worthless.

There have been thousands of people who have become millionaires by way of stock options. This is why they are so appealing. Facebook serves as a very successful example, as many of its employees have become millionaires just from stock options.

How Does a Stock Option Work?

Stock options are granted and exercised through the following example:

1. XYZ, Inc. hires an employee named Sally Jones.

2. A part of her employment package includes XYZ granting Sally the option to acquire 30,000 shares of XYZ common stock at 20 cents per share. This would represent the fair market value of the stock at the time.

3. These stock options will be subject to a vesting period of three years with cliff vesting of one year. This means that Sally has to remain employed with XYZ for one year before she can exercise 10,000 of her options. She can then vest the other 20,000 options at the rate of 1/24 during the next 24 months of her employment.

4. If Sally is fired or leaves XYZ before her first year ends, she will not receive any of her options.

5. Once her options are vested, she can buy the stock at 20 cents per share no matter if the share value has dramatically increased.

6. After three years, all 30,000 of her option shares will be vested if she has remained employed with XYZ.

7. XYZ becomes very successful and goes public, causing the stock to trade at $20 a share.

8. Sally will exercise her options and purchase 30,000 shares for $6,000 (30,000 x 20 cents.)

9. She will then sell all 30,000 shares for $600,000 (30,000 x $20 per publicly traded price). This will yield a profit of $594,000.

Why Do Companies Issue Stock Options?

There are several reasons why a company may want to issue stock options:

  • The options can attract and retain good employees
  • They can help increase morale and motivate employees
  • They are a very cost-effective benefit for employees rather than compensation with cash
  • They help small companies compete with larger competitors when trying to attract employees

Key Issues in Stock Options

There are some key issues that a company must address before it can offer a stock option plan. Typically, a company needs to provide a plan that is flexible. There are also some additional considerations:

  • Maximum number of shares: A stock option plan has to maintain a maximum number of shares that can be issued. The number is largely based on the decision of the board of directors. It generally ranges from 5% to 20% of the outstanding stock of a company. Not all options have to be granted, however.
  • The number of options granted to employees: No formula exists regarding how many options a company will give to an employee. It is negotiable, but a company can set its own guidelines based on the job position.
  • Administration of the plan: Though most all plans will appoint the board as the administrator of the plan, it needs to allow for the delegation of responsibilities to an outside committee. There should be broad discretion with regard to the optionees, the options granted, and the like.

If you need help with start-up stock options, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law, and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.