The first-time founders ultimate guide to understanding stock options

Successful entrepreneurship means understanding tricky concepts like equity.

We put together a comprehensive guide to granting stock options in your startup.

Key tips include: Know the difference between preferred and common stock, and explain to new hires exactly what their compensation package means.

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When you're running a new startup, you probably can't compete with the likes of Google or Amazon on salary. But you can offer promising new hires the chance to play an integral role in your company's success, and to reap the benefits later on.

Equity is a common component of compensation packages at early-stage startups: Employees are granted either stock or the option to purchase stock in your company. If your company is acquired or goes public, those employees might strike gold.

But stock options can be endlessly confusing, even for founders who immerse themselves in entrepreneurship literature. So we consulted a series of experts — including founders, investors, a financial adviser and a lawyer — about the most important concepts to understand and the biggest pitfalls to avoid.

Read on for a comprehensive guide to stock options:

Get legal advice

Don't think that being a scrappy entrepreneur means you can get by without legal expertise. Almost every expert we spoke to emphasized the importance of hiring a lawyer to review important company documents like stock purchase agreements.

Sacha Ross, a partner at the law firm Cooley, LLP, wrote in an email to Business Insider, “The key is that you have a state-of-the-art plan that works from a legal and tax perspective and an adviser that knows how to work with them”.

Ross said founders often make “utterly rational” decisions to change some provisions in the contract based on the needs of the company. But those decisions can have horrific legal implications down the line. For example, they might deviate from provisions on incentive stock options (more on those later in the guide). Then “there's a chance the option is no longer an incentive stock option,” Ross wrote.

Know the difference between stocks and options

Stock and stock options are not the same.

Aaron Hattenbach, AIP, founder and managing member of the investment advisory firm Rapport Financial, said stock options are best described as an “opportunity.” He said, “You're not obligated, but it gives you the opportunity to purchase an asset at a fixed strike price [defined later on in this guide] that is listed in the option agreement.”

Understand the different types of stock

There are many types of company stock, but the two you'll hear about most often are “preferred” and “common.” Typically, investors hold preferred stock, while founders and employees hold common stock.

Harj Taggar, cofounder and CEO of Triplebyte, as well as a Y Combinator alum and former partner, broke it down this way: “There's two ways to get shares in a company: Either you purchase the shares with money, or you give your time and perform some kind of service in exchange for shares.” He added, “VCs and investors are giving money in exchange for shares. And founders and employees are giving time and services in exchange for shares.”

Preferred stock

According to “The Definitive Founders' Guide to Equity,” produced by Capshare, there are a few key points to remember about preferred stock.

Preferred stockholders receive their money first in the event of a liquidation, meaning an acquisition or IPO.

Most preferred stock includes an anti-dilution feature (more on that later in the guide), which means the value of each share doesn't decline when more shares of the company are issued. Interestingly, if a company goes public or is acquired, the valuation is always based on the preferred share price — not the common share price, Taggar said.

Common stock

Common stock is, as its name implies, the most common form of equity.

A subset of common stock is restricted stock, which is typically granted to the company's founders and earliest employees. Hattenbach said, “The earlier you join the company, the more risk you're taking, but also the more upside you have in your equity in the company.”

Restricted stock owners may want to use the 83(b) election, which is a tax strategy that allows you to be taxed on your equity on the date that you received it, not the date it vests, according to Cooley's website. You must file your 83(b) election form within 30 days of being issued the restricted stock.

Taggar said it's important not to mess this part up because “it's the one thing that can't be fixed later on.” It's not just a tax burden for you — it can hurt the company, too, potentially causing an acquisition deal to fall through, Taggar said.

Other subsets of common stock are incentive stock options (ISOs), which are typically granted to any subsequent full-time hires and non-qualified stock options (NSOs), which are typically granted to independent contractors.

Understand voting rights

Voting rights are for company shareholders. In other words, if you've been granted stock options but haven't yet purchased the stock, you don't get voting rights, Hattenbach said.

At certain companies (Google, Facebook, Twitter), founders have “supervoting stock,” which means they have 10 or more votes per share, according to Cooley's website.

Consider who you want to give stock options to in the first place

Sophie Kahn, cofounder of the jewelry company AUrate, said, “At the end of the day, once people have options, they're really invested. But you also need to know that these are people that you want to really have stick around.”

An easy way to think about it is: Do you want this person to potentially own a piece of your business？ “If people feel like they're just employees, so to speak, it's not the same as if they feel that they're owners in the company,” Kahn said.

Read more: VC giant Greylock, a Dropbox and Facebook investor, just hired a new partner to staff its portfolio's startups. Here's the No. 1 trait she looks for in executive candidates.

Think about using equity to win over key hires

Glen Evans, vice president of core talent at the venture-capital firm Greylock Partners, said offering equity as a part of a compensation package can be a way to woo top talent who might otherwise get snapped up by a more established company.

“Startups have more risk, but also more upside,” Evans said. That's why he tells founders in Greylock's portfolio to “make sure you have a tight pitch and vision around your company” and walk potential hires through the outcomes of different scenarios.

Read more: This LinkedIn message took 2 minutes to write and got the sender a job at a successful startup — even though they weren't hiring

Set the strike price

The strike price is how much the employee will pay to purchase the stock, and it's usually based on the company's most recent valuation. The strike price doesn't increase even as the share price increases over time.

Hattenbach said it's possible for employees to negotiate their strike price. For example, if a company just closed a round of fundraising, the employee might ask to set their strike price based on the valuation from the previous round. Founders are typically able to do that, Hattenbach added.

Determine the vesting schedule

The vesting schedule is the period of time until the stock is available for purchase.

Evans said the most common is a four-year period with a one-year cliff, meaning if the employee doesn't stay with the company for a year, they don't get to purchase the stock.

Read more: The startup founder's guide to letting people go efficiently and compassionately

Understand the concept of dilution

Dilution occurs when the value of a stockholder's existing shares declines because new shares have been issued. After all, the value of the company isn't changing. So an increase in shares outstanding translates to a lower value-per-share. As mentioned above, preferred stock is usually protected from dilution.

Be sure to get 409A valuations

A 409A valuation is an independent appraisal of the fair market value of a private company's common stock, according to Carta. The 409A valuation determines the strike price.

Startups need to get a 409A valuation every 12 months, or any time they raise a new round of capital.

Be aware of any lock-up options in your stock purchase agreements

A “lock-up agreement” prevents a shareholder from selling their stock for a certain period of time after an IPO, according to Cooley's website. While length can vary, the SEC says most lock-up periods are 180 days.

Know if the agreement mentions accelerated vesting

Some employees want accelerated vesting in case their company is acquired before the vesting period is up. In that case, they could avoid having to work for the bigger acquiring company by gaining earlier access to heir initial company's stock, according to Wealthfront.

But Ross wrote that this is an area where founders can get tripped up, especially if “all optionees are automatically given acceleration on an exit.” He added, This is often unintended as the language can be really confusing, can serve to unfairly benefit recent hires, and can be a surprise to boards and founders alike.

Even if it's unintentional, Ross wrote, “it can be unfair. For example, a company that gives all of its employees full acceleration on a sale could be faced with a situation where employees hired the month before the sale get full acceleration when the real value was created by the employees who worked day and night for the three years before the sale, which doesn't seem equitable.”

Be careful using standard templates

It's tempting to grab a template you found online, or to use the same document for years.

But Megan O'Connor, cofounder and CEO of the tutoring-software company Clark, sounded a note of caution: “You need to make sure that in that offer you have both the options that you are granting … what percentage ownership of the company that equals in real-time, and what the strike price is given real-time. It's great to have a templated document, but you have to make sure that it's always relevant to the current funding stage the company is at.”

Explain to new hires what their compensation package means

Don't assume your employees have done as much research as you have on the concept of equity. Instead, make sure to have a conversation with new hires about what their compensation package really means. “It's not actually complicated,” Kahn said, “but it's not straightforward.”

Kahn also recommended taking into account your employees' preferences. Some people care more about base salary, while others care more about equity, she said. At AUrate, “that's something that we're very flexible with. It's not fixed.” It's a way to “stay competitive,” she said.