Many venture-backed startups incentivize employees by offering a portion of their compensation as equity. This allows employees to benefit from their contributions and share directly in the company’s growth. In early-stage companies, this equity compensation typically comes in the form of restricted stock or stock options.
For restricted stock, an employee must either pay for shares upfront or pay taxes on their value. As a company’s value increases, the upfront cost or tax on restricted stock can become prohibitive. At this point, companies often begin to grant stock options.
Stock options confer the right to buy company shares at a predetermined price, known as the exercise or strike price. They require no upfront cash, letting employees wait until the company’s future trajectory is clearer before purchasing shares. Stock options usually come with a vesting schedule, which means recipients must work for the company for a minimum period before they can exercise their options.
Under U.S. tax law, there are two types of stock options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs), each with different tax consequences. ISOs can only be issued to company employees by law. Tax and securities laws largely determine the features, drawbacks, and standardization of stock options in venture-backed startups. Section 409A of the U.S. tax code generally requires that a stock option’s exercise price be set at the fair market value of the underlying stock when the option is granted. Nowadays, companies typically establish their stock’s fair market value through an independent third-party valuation firm. This provides a tax safe harbor against the mispricing of stock options and related U.S. tax penalties. Federal and state securities laws generally require stock options to be granted pursuant to an equity incentive plan and only to employees and non-entity consultants of the company.
Stock options can be a valuable tool for startups to attract and retain talent. However, due to complex corporate laws and intricate tax and securities regulations surrounding equity compensation in the U.S. and worldwide, companies considering stock options should work with knowledgeable attorneys and tax advisors to ensure the correct setup and administration of their equity incentive plans.