Employee Equity and Stock Options: Aligning Incentives
Master employee equity. Structure option pools, grant options fairly, and use equity to align team incentives.
Key Takeaways
- Option pool sizing: Typical 10-15% of fully-diluted shares for employee pool (larger if early stage, smaller if mature). Example: 10M shares outstanding, 10% pool = 1M option shares. Distribute to employees based on: Role (CEO more than engineer), seniority (senior more than junior), stage (earlier grant, later smaller). Refresh pool if depleted (common practice).
- Vesting schedule: Typical 4-year vest with 1-year cliff. Meaning: Employee gets 0 shares if leave before 1 year, then 25% after 1 year (1/4th of grant), then monthly 1/48th for 3 years. Example: 100K option grant vests over 4 years. If leave after 1 year, get 25K shares. If stay 4 years, get all 100K. Rationale: Retain employees (cliff discourages leaving early).
- Strike price: Price employee pays to exercise options. Typically set at fair market value (FMV) of common stock at grant date. Example: Stock FMV £1/share, grant 100K options at £1 strike. If company exits at £5/share, employee exercises (pays £100K), gets shares worth £500K (£400K profit). Fairness: Strike at FMV (not below) to avoid tax penalties.
Structuring Equity
Building a fair and effective option program. **Option Pool** Option pool: Shares reserved for future employee grants. Typical size: - Early stage (<£1M ARR): 15-20% pool (larger, need to attract talent) - Growth stage (£1-10M): 10-15% pool (smaller, fewer new hires) - Mature (>£10M): 5-10% pool (small, don't need to grant many) Calculation: | Stage | Shares Outstanding | Pool % | Pool Size | |-------|---|---|---| | Early | 10M | 15% | 1.5M | | Growth | 50M | 12% | 6M | | Mature | 100M | 8% | 8M | Benefit: Pool grows with company (50M shares mature stage, 8% = still meaningful). **Ownership Dilution** Each option grant dilutes ownership. Example: - Early: 10M shares, 15% pool = 1.5M options - After funding round: 15M shares (5M new shares), pool diluted - Later: 20M shares, pool still 1.5M = now only 7.5% (diluted) Refresh pool: - As pool depletes, refresh it - Add new options to pool (refresh grant) - Dilutes all shareholders proportionally - Necessary to continue attracting talent Process: - Every 2-3 years, propose option pool refresh - Get board approval - Update option plan **Equity Breakdown** Example early-stage cap table: | Holder | Shares | % Ownership | |--------|--------|---| | Founder A | 3M | 30% | | Founder B | 3M | 30% | | Early investors | 2M | 20% | | Option pool | 1.5M | 15% | | **Total** | **9.5M** | **100%** | Note: Pool is ungranted shares (reserved for future employees). Fully diluted: - Assumes all options exercised - Example: 9.5M + (future rounds) = 15M at Series A - Founders now 30% each but on larger base
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Start for free →Vesting Schedules
When employees get their equity. **Standard Vesting Schedule** 4-year vest with 1-year cliff: Timeline: - Year 0: 0 vested (cliff period, nothing earned) - Year 1: 25% vested (1M of 4M grant) - Year 2: 50% vested (2M of 4M grant) - Year 3: 75% vested - Year 4: 100% vested Monthly: - Vest 1/48th of grant each month (after 1-year cliff) - Example: 4M grant = ~83K per month vests **Why 4-year vest?** Retention incentive: - If leave before cliff (1 year): Get 0 (strong retention signal) - If stay 4 years: Get 100% (reward loyalty) - Incentivizes staying through ups and downs Fairness: - 1-year cliff: Normal for early employees (not super short or long) - 4-year total: Aligns with company growth stage (can take 5+ years to exit) **Alternative Schedules** 2-year vest with 6-month cliff: - Earlier vesting (good if company accelerating) - Used sometimes in competitive markets 3-year vest with no cliff: - Monthly vesting from day 1 (unusual, not typical) - Rarely used (doesn't retain if person leaves month 1) Cliff deeper (3-year cliff): - Longer cliff (extreme, rarely) - Only for specific roles or situations Standard: 4-year vest, 1-year cliff (use this). **Double-Trigger** Change of control (acquisition): - Normally, unvested options are forfeited - Double-trigger: Options accelerate vesting if company acquired AND employee fired Example: - Employee has 4M grant, 2 years vested (50%), 2 years unvested - Company acquired - Without double-trigger: Lose 2M unvested options (bad) - With double-trigger: Vest all 4M if fired post-acquisition (good) Benefit: Protects employees if acquired and laid off. Cost: Company must account for acceleration (increases earnout/seller proceeds). Negotiation: More senior employees (CEO, VP) often get double-trigger. Junior get single-trigger (standard).
Option Grants and Equity Communication
Granting and communicating equity. **Grant Levels** Different roles get different grants: | Role | Years at company | Grant | |------|---|---| | Founder | Early | 10-30% | | CEO (hired) | Ongoing | 0.5-2% | | VP | Ongoing | 0.2-1% | | Director | Ongoing | 0.1-0.5% | | Senior engineer | Ongoing | 0.05-0.2% | | Junior engineer | Ongoing | 0.01-0.05% | Note: Percentages on fully diluted basis (post-future-rounds). Factors: - Seniority (more senior = more options) - Stage (early = more, later = less) - Role (business roles typically less than engineering) Example offer: - Senior engineer hire at Series B - "We offer: £80K salary + 0.1% equity (16K options, 4-year vest with 1-year cliff, £0.05 strike)" **Strike Price** Price employee pays to exercise options: Typically: Fair market value (FMV) of common stock at grant date. Example: - Grant date: FMV is £0.50/share - Grant: 100K options at £0.50 strike - Employee pays: £50K to exercise, gets 100K shares Exit scenario: - Company sold for £10/share - Employee exercises (pays £50K), gets shares worth £1M - Profit: £950K Tax implications (509A): - Strike at FMV: No immediate tax on grant (incentive stock options, ISO) - Strike below FMV: Immediate tax on discount (not typical) - Strike above FMV: Illegal/not allowed ISO vs NSO: - ISO (Incentive Stock Option): Grant at FMV, favorable tax treatment - NSO (Non-qualified Option): Grant above FMV (unusual) Standard: Use ISO, strike at FMV. **Communication and Documentation** Stock option agreement: - Grant details (number of shares, strike price, vesting) - Vesting schedule (4-year, 1-year cliff) - Exercise process (how to exercise, cost) - Taxes (employee responsible for taxes on exercise) - Change of control (what happens if company acquired) Signed: Employee must sign agreement. Annual statements: - Share number of vested options - Number of unvested options - Strike price - Current FMV (so employee can calculate value) Example statement: - "You have been granted 100K options" - "Vested: 25K (after 1 year), Unvested: 75K" - "Strike: £0.50, Current FMV: £5.00" - "Value if exercised: (25K × £5) - (25K × £0.50) = £112.5K"