Stock At Startups Defined
Startup stock is a form of employee compensation where an employee at a startup is granted stock from the company. Given the high risk of startups, startup stock is often used to lure high caliber employees to join early-stage companies since these employees can benefit in the upside of the stock if the startup becomes a big success.
Startup stock can come in many forms, but we will go over the most popular forms which are stock options and restricted stock. Both can be powerful tools to aligns incentives to give the startup the best chance of succeeding.
Here is an article by Y Combinator on startup stock options.
How Does Startup Stock Work?
If you’ve ever worked in a startup, you understand how challenging, fast paced, and unpredictable things can be. Employees typically where multiple hats and operate under intense pressure with a lot of autonomy. Even worse, salaries at startups are often below market value since capital is a scarce resource.
Because of these factors, employees are often offered equity to offset what they are foregoing by not getting a job at a more established company. Startup equity is typically offered in stock options or restricted stock. Let’s first go over some of the key terms to know.
Key Terms Found In Startup Stock
- Number of Shares – The number of shares is a term in the agreement that outlines how many units of stock the employee will have the opportunity of earning.
- Grant Date – The grant date is the day the employer gives the employee the stock options or units.
- Expiration Date – For options, the expiration date is the day the employee can no longer exercise the options. This is typically long after the grant date and can be up to 10 years.
- Exercise Price – For options, the exercise price is a fair market rate for the shares being offered to the employee. This is the same price the employee will be able to purchase the shares for in the future.
- Vesting Schedule – The vesting schedule is the achievement the employee will need to hit in order to earn the shares. The vesting schedule is typically time-based.
- “One Year Cliff” – A one-year cliff is a common feature in vesting schedules which essentially means the employee needs to stay at the employer in order to earn any shares or options.
Here is another guide on stock options for first time startup employees.
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Startups have many forms of employee compensation that involves providing employees with equity. Two popular types of startup sock are incentive stock options and restricted stock units.
Browse some of our startup lawyers here.
Incentive Stock Options
Incentive stock options, also known as ISOs, are a form of employee stock options that startups routinely use to incentive their employees. Some of ISOs key features are their exercise price, vesting schedule, and expiration date. ISOs are also subject to preferential tax treatment, unlike non-qualified stock options.
ISOs allow for an individual employee to buy shares in the future at a pre-set price. In other words, when the ISOs are issued to the employee, they will have an exercise price which is the current fair market value of the shares. If the value of the shares goes up over the employee’s lifetime at the startup, they will be able to purchase these shares at the pre-set price in the future in hope of earning a profit.
Here is a quick example of how ISOs works:
- John is given 10,000 ISO shares at an exercise price of $1 per share.
- The vesting schedule for the shares is four years with a one-year cliff.
- John stays at the startup for 5 years, so his shares are fully vested, and the startup is acquired at a price of $5 per share.
- John then chooses to exercise his options, which means he purchases the 10,000 shares at $1 per share for a total of $10,000.
- The shares John receives are worth $5 per share, or $50,000. John has netted a profit of $40,000.
Here is an article on Incentive Stock Options.
Restricted Stock Units
Restricted stock units (RSUs) are another form of compensation routinely used with startups and are typically given to executives. While RSUs have a vesting schedule, similar to ISOs, they do not need to be purchased when they vest. This makes them different than ISOs.
Another way of understanding this is an employee will be granted RSUs on a certain date, and after the RSUs vest, they will be transferred ownership to the employee at this time.
One thing that makes RSUs different is they are regulated by the SEC and fall underneath insider trading regulations. Typically, RSUs are issued to executives that know what is going on at a company.
Here is a quick example of how RSUs work:
- John is granted 1,000 RSUs when joining a late-stage startup.
- The RSUs come with a vesting schedule of four years with a one-year cliff.
- After one year, 25 percent of John’s RSUs have vested so he now owns 250 shares.
- After four years, John now owns 100 percent of the RSUs, which means he owns 1,000 shares.
- Notice, John did not need to exercise his shares like he would have with stock options.
Here is an article on Restricted Stock Units.
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Stock Option Agreements and Restricted Stock Units Agreements
The two types of startup stock we’ve gone over are granted to employees by using a stock options agreement or a restricted stock unit agreement, which are legally binding documents that outline offers to employees and are executed to govern the relationship between the employer, employee, and startup stock. These agreements are typically accompanied by an employment contract, noncompete agreement, and other types of employment contracts.
Here is an example of a Form of Restricted Stock Unit Agreement.
Basics of Exercising Startup Stock Options
Employees that receive stock options will be faced with the choice of exercising them in the future. This is one of the key features of employee stock options. Exercising startup stock options means purchasing the shares at the exercise price that was established in your stock options agreement.
The way an employee benefits from exercising their options is if the current price of the stock is much higher than the fair market value of the price when the options were granted. This means the employee would stand to make a profit by buying the shares. The profit is the difference between the current market value of the shares minus the exercise price multiplied by the number of shares.
Here is an article about when you should exercise your stock options.
Getting Help With Startup Stock
Startup stock, employee stock options, restricted stock and other types of employee compensation can be complicated to understand and negotiate. If you need help, feel free to post a project in our marketplace to work with a lawyer familiar with employee compensation and startups. It is free to post projects and receive bids.
