The Human Capitalist Series P.2: Stock Options

Stock options are the most common form of equity incentive for early-stage startups. A stock option grants the option holder the right to purchase a specific number of shares of the company within a fixed period of time at a preset “exercise” price, generally following the satisfaction of time-based and/or performance-based service conditions (also known as “vesting”).

Vesting of Stock Options

The standard vesting schedule is 25% vesting after the first year, with the remainder vesting monthly in equal amounts for the following three years. This vesting schedule is commonly referred to as four-year vesting with a one-year cliff. However, options can be granted fully vested without triggering taxation as well.

Pros and Cons of Stock Options

• Pro: The cost is low to administer stock options and maintain compliance with laws.
• Pro: Stock options are easily understood by employees and may therefore have the greatest incentive effect.
• Pro: Stock options are easy to administer across many foreign jurisdictions (as compared to “full value awards” such as stock bonuses and RSUs).
• Pro: Stock options are favored by employees because the employees can control the timing of taxation and the decision whether to put any money at risk. Most optionees of private company stock tend to wait until their employment terminates, a change of control occurs, or an initial public offering (IPO) is completed before exercising their options.
• Con: Stock options generally must have an exercise price not less than the then-current fair market value, which often means obtaining a third-party valuation of the underlying common stock at least once per year (typical cost: less than $7,000 per year).
• Con: Employers may feel the need to grant larger awards as options, as compared to stock bonuses or RSUs, to account for the employee’s need to pay the exercise price on an option.
• Con: If the fair market value of the common stock drops below the exercise price, the option is “underwater” and may provide less incentive than full-value awards (such as stock bonuses and RSUs).

See the next post for an overview of the U.S. federal tax implications of stock options.