Stock options become an important element of leveraging the potential value of your startup, particularly when you have a grand vision but paucity of funds. This has different implications for entrepreneurs and employees. I’ll elaborate on the various options, challenges and impact.
The following are the challenges from the entrepreneur’s perspective.
As an entrepreneur, stock options are a good way to attract great talent, since really good people will want a part of the value they help in creating, above and beyond their salary. This has a benefit of helping you attract people who are aligned on the vision of the company. It’s also wise to give them on a selective basis.
Unlike the US, where the startup culture is rife and consequently there is awareness about the upsides, giving rise to motivation amongst employees and a willingness to accept a lower salary, Continental Europe is still conservative. Due to this, employees are often willing to accept stock options on top of their expected salary (with pension and annual holidays to boot) but are unwilling to see this as a trade-off. In such a scenario, the best option is not to give them any. If there is no appreciation of stock options, which ultimately can provide your employees with a significant future upside, giving stock options is unlikely to result in any increased motivation or drive to achieve.
The logistics of maintaining stock options is also not trivial, since you do have the onus of ensuring that you maintain fairness and transparency in how they are given. Beyond this, when the options convert into equity, you always run the risk of the equity not being fully liquid and saleable. The reason this is a risk is that your employees may leave taking the equity with them. The quantum is not material; what is material is that future investors or buyers may require all signatures. Tracking these ex-employees is far from trivial, and you always run the risk of them holding you hostage.
Employees also have certain points to consider.
Given the option between options and equity, it is smarter to get equity if the company is yet to get an investment at a high valuation. This limits the risk of the perceived value been seen as being high, particularly because in many countries, this is likely to be considered as taxable income for the year. In case the equity already has a high valuation, it’s better to have options to mitigate the risk of taxes, given that this cannot be sold in the market, and will continue to not be saleable for several years to come.
If your employer has defined the equity to be provided to you, it is better to have an agreement prior to investment so that the future transfer of shares is captured at the earlier and lower valuation, so that even if there is incidence of tax, it is at the lower valuation.
Finally, if your only option is stock options, it is better to have a trigger that ensures that they are transferred to you only at the time of a liquidity scenario, such as when the company gets sold. In this way, even though you may get taxed on them, the taxes are reduced from the real inflow on sale. Needless to say, the trigger needs to be controlled by you so that in the eventuality that you leave the company in the meantime, you don’t leave money on the table simply due to a tax optimisation strategy.