Options v. Stock for early Startup employees

Additional reading:

Equity compensation is a core component of how startups recruit and retain talent. The two most common types of equity compensation at early stage are Options and Stock.

An option is the right to purchase stock at some point in the future, at an “exercise price.”

Stock, on the other hand, is a full voting security in the company, with all of the economic rights of ownership. 

The core driver of whether companies award stock or options to early hires is taxes. No one wants to have to pay the IRS tax for receiving equity, but under the broad framework of how IRS rules work for compensation, if you receive something (from your employer) worth more than you pay for it, the spread (the difference in value) is compensation, and therefore you owe taxes on it; even if you only got, in a sense, a “paper” gain.

At the very early stages of a startup, the “fair market value” (FMV) of stock is very little from an IRS perspective, because revenue is low or non-existent, and there hasn’t been much financing setting a third-party price. Issuing stock to employees is therefore fairly easy to do without a big tax hit, because the recipients can just pay the FMV of the stock; typically par value or close to it – fractions of a penny. No tax problem. 

As the company increases in value, however, having people pay the FMV is no longer feasible; it could mean having to pay thousands of dollars, or more, for the stock. This is what drives startups to switch to options.

Without getting too in the weeds, the IRS has certain “safe harbor” rules that allow employees to receive options on a tax-free basis as long as certain conditions are met, and one of those conditions is that the exercise price equals the fair market value on the date of grant. This safe harbor is the reason options are the primary form of equity compensation for post-seed stage startups; to avoid sticking recipients with a tax bill.

A company can be worth millions of dollars, but as long as its option grants have a FMV exercise price, employees receiving those options can (i) pay nothing to get the option (though they’ll need to pay to exercise it), and (ii) not owe the IRS anything for receiving the option. 

An equity incentive plan (the broad term for the legal paperwork behind “option pools”) is not a simple document. Specialized law firms and services have equity plans that have been vetted by appropriate tax counsel to ensure compliance with tax rules. Do not just pull something off of google and use it. You won’t like the long-term results.