Startups Need Option Plans if They Want to Hire Employees
When it’s time to hire, startups need a way to incentivize new talent. Since startups can’t afford to compete with the salaries offered by established companies, they usually offer employees equity. In order to compensate employees, the startup will have to create an equity incentive plan (EIP), which is also commonly referred to as an option plan.
What is an option plan and why is it necessary?
Any startup that wants to attract employees but is trying to conserve capital (or simply doesn’t have any) will need to create an option plan. Employees, knowing that most early-stage startups cannot offer them market-rate salaries, will expect that a startup will be able to offer them equity instead. For employees, most companies prefer to issue stock options, which differ slightly from common stock: while common stock grants represent actual, immediate ownership in the company, stock options do not represent ownership until they are exercised—they’re simply the right to purchase common stock at a set price. Companies give themselves the ability to issue stock options by creating an option plan.
An option plan, in simple terms, is a set of legal documents that gives a startup’s board of directors the power to issue stock options to employees. Usually, a startup adopts an equity incentive plan laid out by a lawyer, which can be surprisingly expensive. To solve this problem, Gust Launch has released a much more affordable option plan that helps startups effectively set up and issue stock option grants on-platform to help grow their team. With Gust Launch’s equity incentive plan, founders can easily issue stock option grants online and automatically record them on the company’s existing cap table with the assurance that they are doing everything according to startup best practices.
Incentives in the form of stock options aren’t just helpful for bringing in talent; they’re also important for getting employees to continue working for the startup. That is because stock options are typically subject to vesting. Vesting is a grant feature that distributes exercise rights over a set period of time. Industry best practice for employee stock options is a four year vesting period with a one year cliff. The cliff refers to the period of time an employee has to wait before they can exercise any of their options. Typically, at twelve months, a quarter of the stock options become exercisable, with the rest of the unvested options split monthly over the remaining vesting period.
In most cases, a startup won’t start rapidly hiring employees until after successfully fundraising, which means that a startup doesn’t necessarily need an option plan prior to that time, but adopting an option plan before fundraising can still be beneficial. Investors will require that startups adopt an EIP anyway, so having one in place and putting consideration into employee compensation can demonstrate to investors that a startup is serious about their venture and is working to attract good candidates.
How option plans work
Since most founders aren’t lawyers, they typically have to ask their attorneys to create their option plans. When they adopt option plans, founders have to answer a lot of questions: “how many employee options will I need to issue? When? What happens to these options after a round of funding?” A professional takes the guesswork out of the equation so founders don’t have to worry about trying to answer questions on their own or whether they are handling an option correctly and legally. Now, so does Gust Launch.
Founders might not realize that option plans require ongoing work after they are created and implemented. Founders will need to adapt their option plans to accommodate future hires and funding rounds. With each round of funding, they will have to refresh their employee option pools in order to have enough options available to hire new people. This means they’ll need to be able to track the number of options that remain in their pool. Founders will also need to be able to measure their hiring progress against their initial hiring plan, in order to know who they still need to hire.
Creating an option plan is difficult because it involves making decisions that many founders might not be fully equipped to make on their own. More specifically, founders need to be able to determine the exact number of employee stock options they have to issue, and how many options they need to issue to a specific employee in order to incentivize them to come on board. Founders also need to understand how dilution affects their employee stock options after a round of funding has closed. Ultimately, if founders want to successfully attract and retain talent, they will need to properly create, administer, and manage an option plan, and with Gust Launch, they can do so both seamlessly and affordably.
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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.