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Posted: June 03, 2013

Creative compensation

A guide to startup stock options

Dan King

Colorado is leading the charge in the startup arena and creating job growth.  As a result, these companies compete for quality talent. 

Startups with limited cash resources must come up with alternative but meaningful forms of compensation, such as more time off, unusual perks and progressive work environments.

There's another popular form of deferred compensation: stock options. These deferred compensation plans are excellent for attracting and retaining talent by aligning their economic goals with the company’s economic goals. They are also a benefit to the person who holds the stock long enough to take advantage of favorable tax rules.  

The key purpose of stock options is to provide an ownership stake in the company, also known as equity.  Equity is provided to talent who generally: 1) are earning a rate of pay less than market; 2) are a key hire, or; 3) must be retained. 

The concept is simple and often misunderstood.  Here are the basics: 

Companies “grant” employees the “option” to purchase a certain number of shares of company stock at a pre-determined purchase price amount, called a strike price, beginning on a specific date, usually the date of hire.

The option to purchase the stock is subject to a waiting period called vesting, which can occur at multiple times. When stock options vest, a certain numbers of shares are eligible for purchase. This process gives employees the incentive to stay with the company and build enterprise value over time: The longer the employee stays, the more options vest.

Two common types of stock grants are: 1) Incentive Stock Options (ISO); and 2) Restricted Stock Units (RSU). 

Incentive Stock Option (ISO) – The vesting period is typically four years.  Once the stock options are vested, the employee can purchase the options and begin the stock ownership holding period.  The key benefit to this plan is that it is easy to manage and encourages employees to help build enterprise value.

Restricted Stock Units (RSU) – These grants provide ownership of the stock on day one of grant, also at a pre-determined price.  However, the stock is tied to a vesting schedule and subject to a “right of repurchase."  If the grantee leaves the company, the company can buy back unvested shares.  One key benefit of the RSU plan is immediate stock ownership.

The follow-on question is usually the amount of equity to grant. There is no one right answer, but there are general guidelines.  The compensation strategy often discussed is the concept of “total target compensation," not just cash.  Put simply, total target compensation is an “all in” compensation number when considering all of the forms of benefits (salary, time off, equity). 

These situations often manifest themselves when someone is considering going to work for one to two types of companies: 1) a large, established company that can afford to pay higher salaries; or 2) a smaller startup that can’t pay the higher salaries but can provide a base salary and equity.  If you and your potential company are vastly different on cash compensation, equity helps bridge the gap. 

Let’s quickly review an example of the wealth generation potential of equity.  Both ISOs and RSUs are represented below.

Let’s say you are granted 10,000 stock options or RSUs vesting over a four-year period, at a 10-cents per share strike price (the cost).  After four years, you are fully vested.  You exercise the options (purchase them) and own 10,000 shares of stock that cost you $1,000 (10,000 shares X $0.10 per share = $1,000).  During that same four-year period, the company increased its stock value from 10 cents to $10 per share.  Even better, the company is sold resulting in the sale of the stock, called a “liquidation event." 

To the employee, the gross potential cash windfall is $100,000 (10,000 shares X $10 per share = $100,000) before considering the $1,000 cost of the shares or tax.  Not bad for four years of work.

A word of caution: do not underestimate the potential tax consequences. While capital gains rates may be available, the alternative minimum tax may also apply.  Consult a tax accountant or attorney before you take action.  Your finance team can help maneuver the basics to get you started.  Now get out there and help build value in your company!

Dan King is a financial operations leader with significant experience in venture capital and private equity-backed technology companies in software, SaaS, Cloud and ecommerce business models. He began his career as a CPA with KPMG in the Silicon Valley and is active throughout the Colorado technology and small business community.  Dan can be reached at djk235@hotmail.com

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