How to give out shares and share options in your startup
Startup equity is a precious commodity and should be given away sparingly. Equity is divided amongst co-founders, used t...
It’s the classic problem for ambitious startups: you want to attract top talent to help you grow your business, but you don’t always have the money to pay top salaries. That’s why many startups offer employees equity as part of their employment package.
Of the companies that offer equity to their employees, most choose options rather than shares. At SeedLegals, we’ve helped thousands of companies set up their share option schemes and we’re often asked what the difference is between shares and options – and what the right time is to grant these. We’ve turned our answers into this short guide to help you better understand shares and options .
The fundamental difference between shares and options comes down to timing. Someone who purchases shares becomes a shareholder in the company immediately. Buying these shares often comes with certain rights, like voting rights and dividends – when these are given along with the share.
Granting someone options gives them the right to buy shares in the future, but they don’t become a shareholder or get any rights associated with the shares at the time the options are granted to them. Instead, Option holders will only become a shareholder and receive these rights when they actually own the shares.
So far, it sounds simple. Let’s break down what the differences are between shares and options across the following three categories:
Shares give the holder immediate ownership of a stake in the company. Options are the promise of ownership of shares in the company at a fixed point in the future, at a fixed price. Option holders only become shareholders when their options are “exercised”, which converts the options into shares.
Whether you’re granting shares or share options, it’s important to be careful about how much equity you’re giving away. Although an options scheme is a good way to incentivise your employees or consultants, there may be implications for future fundraising if you give away too much equity.
Do shares give immediate ownership?
Yes. When shares are issued and allocated, the holder immediately becomes a shareholder and is given equity ownership in the company. Depending on the terms governing the share classes in your company, the shareholders will have all the shareholder rights attached to the share class they are in, such as voting rights, rights to dividends and rights to their share of the company’s assets if it’s wound up, liquidated or sold.
When your company is in its very early stages, it’s more common to give equity in the form of shares when a key C-suite member is hired.
Example: Mary is issued and allocated 1,000 ordinary shares that carry one vote per share and the right to dividends. The company has a total share capital of 100,000 ordinary shares (including Mary’s 1,000 shares). This means Mary owns 1% of the company (1,000/100,000), has 1% voting rights, and can receive 1% of the dividends, if dividends are ever paid (few startups pay dividends in the early stages).
Another critical difference between shares and options is how they are purchased. This difference impacts both the person receiving equity and the company granting it. So it’s important to think carefully about which form of equity compensation to use to avoid problems down the line.
When shares are granted as part of an employment contract, they are often issued at a discounted value. If shares are issued at a discounted value, the employee spends less for their shares compared to the market rate, and they won’t need to pay any more in the future.
This is different to a funding round – usually when investors purchase shares as part of a funding round, they would have to pay a premium price for the shares they are acquiring .
Example 1: Mary, who is an employee of the company, is issued 1,000 ordinary shares at a value of $0.01 each. Mary will pay $10 (1,000*$0.01) to the company for those shares, and will own them on allotment.
Example 2: Tom, who is an investor investing in your company, is issued 1,000 ordinary shares at a price per share of $10). David will pay $10,000 (1,000*$10) to the company for the shares and will own them on allotment.
No money or equity changes hands when options are granted or vested. Instead, the option holder pays the “exercise” or “strike” price when they choose to exercise their options and convert them into shares. Although the company granting the options can freely set the exercise price, companies tend to set the exercise price at a nominal price (e.g., $0.01 per share) or a discount to the fair market value of a share when the options are granted. One way to ascertain the fair market value is based on the price per share that investors paid in the most recent funding round.
Example: Alice is granted 1,000 options with a strike price of $20 per option. After three years, if Alice wants to exercise the options, she will need to pay the company a total of $20,000 (1,000*$20).
Vesting refers to the period of time over which shares and options are “earned”. The holder only fully owns the equity (shares or options) after this period of time has passed.
While a vesting period can be set for both shares and options, there’s a difference in the ways shares and options vest. Usually, shares reverse vest and options forward vest.
Shares are issued and allotted to a shareholder upfront. If the shareholder leaves the company before the end of the vesting period, they will be forced to sell the unvested shares back to the company – usually at nil or a nominal value.
It’s common to see startup founders on a reverse vesting schedule for their shares. It helps avoid a situation where a major shareholder suddenly leaves the company and takes a large stake of equity with them. This can make the company uninvestable.
Example: Mary is issued and allocated 1,000 ordinary shares with reverse vesting on a four-year period. 250 ordinary shares are reverse vested each year. After one year, Mary leaves the company. Because a reverse vesting condition was in place, the company has the right to repurchase the 750 unvested shares from Mary.
This means that options are earned in batches over time, usually over a period of three to four years. A vesting schedule might also be set up so that the employee has to achieve certain milestones to earn their options.
Setting a vesting schedule for options is helpful to incentivise the employee. The longer they stay with the company, the more options they vest and the more options they’ll be able to exercise.
Example: Alice is granted 1,000 options vesting over four years. After one year, she leaves the company, with only 250 options vested and the remaining 750 options unvested.
Depending on the terms of the option grant, Alice might be able to exercise her vested options at this stage. Companies will often impose limitations, such as a condition that options can be converted only when the entire allocation has vested, or only between 30 and 90 days after the option holder has left the company.
Issuing shares and options will have tax implications for companies as well as recipients, including employees and advisors. The nature of any tax implications will depend on a number of factors such as the market value of the shares, an employee’s country of residence, and the jurisdiction of the company’s incorporation. When in doubt, consult a tax advisor.
In most circumstances, setting up a share options scheme is one way to reward and incentivise your employees
You might have heard that setting up an employee options scheme is expensive, difficult and time-consuming. Here at SeedLegals, however, it’s simple to create the documents you need in a couple of clicks and manage your scheme online yourself – and we’ll help you at every step.
Previously setting up an option scheme was complex, time-consuming and expensive. At SeedLegals, we’ve made it dramatically easier. And as with all SeedLegals services, we’re on hand to help every step of the way.
If you have any questions, or still not sure on the best way to go, we’re here to help. Get in touch with our team who will guide you and help you get started.
*Disclaimer: The information contained in this article does not constitute and should not be treated as legal, tax, accounting, or financial advice.