Employee Equity: Options

by Fred Wilson for AVC Blog, October 18th, 2010.

A stock option is a security which gives the holder the right to purchase stock (usually common stock) at a set price (called the strike price) for a fixed period of time. Stock options are the most common form of employee equity and are used as part of employee compensation packages in most technology startups.

If you are a founder, you are most likely going to use stock options to attract and retain your employees. If you are joining a startup, you are most likely going to receive stock options as part of your compensation. This post is an attempt to explain how options work and make them a bit easier to understand.

Stock has a value. Last week we talked about how the value is usually zero at the start of a company and how the value appreciates over the life of the company. If your company is giving out stock as part of the compensation plan, you’d be delivering something of value to your employees and they would have to pay taxes on it just like they pay taxes on the cash compensation you pay them. Let’s run through an example to make this clear. Let’s say that the common stock in your company is worth $1/share. And let’s say you give 10,000 shares to every software engineer you hire. Then each software engineer would be getting $10,000 of compensation and they would have to pay taxes on it. But if this is stock in an early stage company, the stock is not liquid, it can’t be sold right now. So your employees are getting something they can’t turn into cash right away but they have to pay roughly $4,000 in taxes as a result of getting it. That’s not good and that’s why options are the preferred compensation method. (continue reading… )

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