The Founder’s Guide to Employee Stock Options

If you’re an early-stage startup founder, you’ve probably run into some of these challenges:

• Limited cash flow: With limited financial resources, you may not be able to offer competitive salaries compared to larger, more established companies.
• Attracting talent: Without the ability to offer high salaries, it can be challenging to attract top talent – especially highly skilled employees who have other job opportunities with better compensation packages.
• Retaining talent: Even when you do manage to attract talented employees, retaining them can be difficult, especially if larger companies try to poach them with better compensation packages.

In Mantle’s Founder’s Guide to Employee Stock Options, we’ll dive into how you can use employee stock options as a valuable tool for attracting and retaining talent while aligning employee interests with your company’s success.

What are Employee Stock Options?

Employee stock options (ESOs) grant employees the right to purchase a specific number of company shares at a predetermined price within a specified period. ESOs will typically come with a vesting schedule. A vesting schedule is a timeline or plan that outlines when an employee gains ownership of their stock options. Once vested, they have the option to exercise their options and become shareholders.

How Employee Stock Options Work

Understanding how ESOs work is essential for startup founders navigating compensation strategies. The first step startups need to take if they want to begin using ESOs is undergoing a 409A valuation. A 409A valuation is the valuation of a private company’s common stock, typically used for setting the exercise price (also known as the “strike price”) for stock options. This valuation should be performed by an independent firm and ensures the exercise price is justifiable and compliant with regulatory requirements.

409A Valuations in the US and Abroad

409A valuations are required for US-based entities but are optional for others. Canadian and global entities do end up adopting the practice of using 409A valuations once they’re in the US venture ecosystem.

💡 Mantle Tip: 409A valuations expire every 12 months, so you should be conducting 409A valuations at least once a year or whenever significant events occur (e.g. fundraising, M&A activities, or other changes in business). 

1. Granting Employee Stock Options

• Issuing ESOs: Startup founders issue stock options to employees as part of their compensation package. They’re often used as an incentive to attract top talent and motivate employees to contribute to the company’s growth. Beyond employees, issuing ESOs is also valuable to advisors, consultants, board members, and other professionals helping you along in your startup journey. 
• ESO Terms: Employee stock options come with specific terms, including the number of shares granted, the exercise price (strike price), the vesting schedule, and the expiration date.

2. Vesting Schedule

• Vesting Period: Employee stock options typically vest over a predetermined period, incentivizing employees to remain with the company for a certain duration before fully owning the options.
• Cliff Vesting: Some options may have a cliff vesting period. This is where a significant portion of options vest after a specified period, such as one year, with the remaining options vesting gradually over time.

💡 Mantle Tip: Keep things simple and consistent so your vesting schedule is easy to track over time. The most common vesting schedule typically consists of a one-year cliff followed by monthly vesting increments over a four-year period, calculated as 1/48th of the total options granted per month. However, if you do opt for customized or bespoke vesting structures, Mantle has you covered as well. 

3. Tracking Employee Exercises

When it comes to employee stock options, accurately tracking ESOs becomes a crucial step. Tracking employee exercises will consist of:

1. Validating that the employee has vested options available for exercise.
2. Collecting the total exercise price by calculating the quantity of shares multiplied by the exercise price per share.
3. Issuing a share certificate for the resulting share grant.

💡 Mantle Tip: Fortunately, if you’re using Mantle, these steps can happen automatically, streamlining the process and minimizing manual effort while ensuring accuracy and compliance.

Other important pieces to note:

• Exercise Price: Employees can exercise their options to purchase company shares at the predetermined exercise price.
• Tax Implications: When options are exercised, employees may incur tax liabilities based on the difference between the fair market value of the shares at the time of exercise and the exercise price.

4. Holding Shares

• Option Ownership: Once exercised, employees become shareholders and have the option to hold onto the shares or sell them in the open market. However, employees should be aware that they might not be able to sell their shares for years, as most shareholder documents restrict share transfers without board approval, typically granted only under exceptional circumstances or for trust placements.
• Long-Term Incentive: ESOs provide employees with a long-term incentive to contribute to the company’s success, as they benefit from any future increase in the company’s stock price.

5. Managing the Post-Termination Exercise Period (PTEP)

When an employee (optionee) leaves the company, there is a post-termination exercise period (PTEP) which provides them with a certain window to exercise their vested stock options. Oftentimes, the PTEP is set to be anywhere from 30-90 days after the optionee ceases employment. 

How Large Should Your Option Pool Be? 

When determining the size of your option pool, you should expect to create a pool equivalent to 5-15% of the company’s equity for every financing round. A well-sized option pool is crucial because it ensures enough ESOs are available to attract and retain talent at various stages of growth. Maintaining a sufficient option pool also demonstrates the company’s commitment to its workforce and helps foster a culture of ownership and alignment with the company’s long-term goals. 

Benefits of Employee Stock Options for Startups

Attract Top Talent & Foster Commitment

Employee stock options are a powerful tool for startups to attract and retain top talent. In the fiercely competitive landscape of hiring, especially in sectors like tech and finance, offering ESOs can be a game-changer. Skilled professionals are not only looking for competitive salaries but also for opportunities to be part of something bigger and potentially more rewarding. ESOs offer that promise by allowing employees to share in the success they help create. This not only attracts talented individuals but also fosters a deep commitment to the company’s mission and success. 

Alignment of Interests & Cultivating Ownership Mentality

ESOs are more than just a compensation tool; they cultivate an ownership mentality among employees. When employees have a stake in your company’s performance, they are more likely to think and act like owners rather than just employees. This alignment of interests between employees, the company, and its shareholders can lead to greater focus, dedication, and innovation. 

Retention & Long-Term Vision

Vesting schedules are designed to encourage long-term commitment to the company. As employees reach milestones and stay with the company over time, they earn the right to exercise more of their options. This incentivizes employees to stay onboard and contribute to the company’s growth over the long haul. Additionally, ESOs often come with a “cliff” period, where employees must stay with the company for a certain period before any options vest. This further reinforces loyalty and discourages turnover.

Cash Conservation & Financial Flexibility

Startups, especially in their early stages, often face cash restraints. Offering stock options allows them to conserve cash by providing a portion of employee compensation in the form of equity rather than pure salary. This not only helps in managing cash flow but also enables startups to attract talent they might not otherwise afford. By leveraging equity as a form of compensation, startups can allocate their limited resources more strategically, investing in growth initiatives while still rewarding and motivating their employees. 

How Can Mantle Help? 

Mantle provides several tools and functionalities to streamline the management of ESOs for startup founders. 

• Option Grant Burndown Functionality: Allows founders to track and visualize their option pool over time. This enables founders to monitor the utilization of ESOs and make informed decisions about future grants. 
• “Include Drafts” Functionality: Founders can easily manage and incorporate pending option grants or revisions into their overall ESO management strategy, ensuring all pending grants are accounted for and seamlessly integrated into the company’s compensation plans.

To see these tools in action, book a free demo at withmantle.com/demo. 

Conclusion

Employee stock options are a powerful tool for startup founders to incentivize and reward employees while conserving cash and aligning interests with the company’s success. By understanding how ESOs work and their benefits, founders can effectively leverage this compensation strategy to drive growth, attract top talent, and build a thriving company culture.

As you navigate the complexities of startup compensation, consider the strategic implementation of employee stock options as a key component of your employee incentive program.