A brief introduction to share options for startup employees

by Scott Taylor
24th September 2017
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Employee ownership is a defining characteristic of startup culture.

Founders have embraced share options as a core fundamental to compensate for the high risk nature.

Share options help align and retain employees. They also reward value creation and encourage long term thinking.

Personally, I can’t imagine starting a business without giving a portion of it to the team. They will be the people to ultimately build the company.

Unfortunately when asking around, I found that most employees (through no fault of their own) still don’t understand the basics of share options. There’s pretty much nothing online. When I did find something, it was confusing and lacklustre. To make things worse, founders seldom take the time to sit down and explain to everyone exactly how the ownership works (maybe because they themselves don’t know!)

This is why I’ve written this introduction to share options for startup employees. I go into a lot more detail in my book – The 10 Minute Guide to Your First Startup Job.

So, in practice, how does employee ownership work? Typically it’s through granting share options to team members. This is done through an Employee Share Options Plan (ESOP).

An ESOP is an allocation of shares that will be granted to employees in the future in the form of share options. The ESOP details how many shares individual employees will receive. As well as the terms attached that will govern the grants.

Timeline of an ESOP

Founders create an ESOP by setting aside a portion of the company to be allocated to current and future employees. Usually around 20-25% of the startup. Together with the Board of Directors they then issue these shares to employees as options packages granted for hiring, promotion and retention. Employees receive all of their options upfront, but the company maintains a right to force forfeit that diminishes over time through a process called “vesting”. Options are exercised by employees when the company is acquired or taken public. The employee pays the “strike price” to acquire the shares, but those shares are now marketable at a higher value.

How much will you get?

The percentage of the option pool, or the £ amount, will depend on a number of factors: stage of the startup (super early stage vs. later stage), your role within the startup (management vs. junior support staff), geography and other externalities.

Running through an example (all made up)

Head of Customer Support (£36k salary & 0.8x options multiplier)

Startup was last valued at £4m, raised £2m. Current valuation £6m. 50,000 diluted shares

Step 1
£ value of options grant = £36,000 x 0.8 = £28,000

Step 2
Current share price = £6m / 50,000 = £120

Step 3
Options grant = £28,000 / £120 = 233 shares

Note that this employee received 0.47% of the diluted shares outstanding; however, the grant is communicated as a £28,000 grant of 233 options, rather than as a percentage ownership stake in the company.

Good CEOs / founders will have a transparent approach on how they segment the team, establishing a standardised multiple of base salary to be granted as an options package. This helps everyone understand the ballparks associated with each role. It also reduces the scope and distraction of actively negotiating packages with employees. Most people should view it as fair and transparent.

What’s the ‘strike price’ of an option mean?

The strike price is the amount that the employee must pay to turn one option into one share of stock. Also known as the “exercise price”. Options are “struck” at a specific strike price when issued; the holder must pay this amount in order to exercise the option.

The expectation is that the shares will have significantly increased in value, and the holder will profit from the spread (as can be seen in the diagram below). Regulations for how strike prices can be set will vary by region – it’s generally in the best interest of both company and employee if the strike price is set as low as possible.

To continue the example above, if the strike price was £120 – let’s say a year has passed, and the company has been acquired for £130 per share. This would mean the £28,000 grant is now £30,090. The option was “in the money”.

What’s a ‘vesting schedule’?

The vesting schedule is the timetable over which an employee accrues the right to keep the options that have been awarded. A typical vesting schedule for a UK venture backed startup would be over 4 years with a 1 year cliff. A one year cliff means that you will not get any shares vested until the first anniversary of your start date. At the one year anniversary, you will have 25% of your shares vested. After that, vesting occurs monthly.

Transfer restrictions

If you ever choose to sell your shares, this is probably one of the most important sections of the options agreement. Even more so due to the fact that startups are typically taking longer to exit, in some cases 10-12 years. If you have £28,000 locked up in shares (as in the example above), if you want to pay off debt, or buy your first house, you’ll want to pay close attention to the transfer restrictions. These dictate who you can sell your shares to, as well as how and when. Let’s jump into the two most common types of transfer restrictions in options agreements.

The first is Right of First Refusal, or ROFR. It simply means that the company has a right to purchase some or all of the shares you were planning on selling rather than allowing you to sell to the proposed buyer. For you, as the seller, it leads (most times) to the exact same financial outcome as if you’d sold to the proposed buyer. A company typically has 30 days to decide whether to exercise its ROFR.

The next restriction requires board / company approval prior to a sale. It’s pretty self-explanatory – the company or board have the final say on whether you can sell your shares to the proposed buyer.

Closing words

I did say this was going to be a brief introduction, but at least now you may have a better understanding of the basic components of share options. Ensure that you have a full understanding of the docs before you sign them.

Also, it’s surprising how many startups will promise you the docs in a couple of months – “they’re just waiting on x from the lawyers”. Until you’ve received and signed an option agreement, you technically don’t own share options.

Further questions to consider asking:

  1. How long the company’s current “option pool” will last
  2. How much more cash the company is likely to raise (so you can ascertain potential dilution)
  3. How much, if any, debt has the company raised? (if the company is acquired, any debt will have to be paid first)
  4. What happens if you’re fired / quit
  5. What are the transfer restrictions

P.S. This article should not be used as a substitute for legal advice from a professional.