Startup Stock Options: How to Create a Stock Option Plan for Your Startup

Startup founders, when you're building a new company, attracting top talent is just as crucial as securing funding. One of the best ways to motivate and retain employees? Company stock options.

A strong stock option plan makes early hires long-term stakeholders, linking their success to the company's growth. Let’s look at how to create a stock option plan that works for your startup without unnecessary complexity.

What are startup stock options?

Startup stock options let employees buy company shares at a set price after a certain period of time, giving them a chance to benefit if the company's value grows. These options are designed to attract and retain top talent by offering them a stake in the company's future success.

When employees receive stock options, they don’t own shares right away. Instead, they gain the right to buy them at a predetermined price (the "strike price") after meeting certain conditions, like staying with the company for a certain amount of time. If the company grows and its stock value increases, employees can purchase shares at the lower strike price and potentially make a tidy profit for themselves.

Another type of equity compensation is the Restricted Stock Award (RSA). With RSAs, employees receive actual shares of a company upfront rather than just the option to buy them later. However, these shares usually come with certain restrictions, such as a vesting schedule and the company’s right to repurchase unvested shares if the employee leaves early.

RSAs provide immediate ownership and potential tax advantages, but they require upfront commitment. Stock options, on the other hand, give employees flexibility so they can decide whether they want to invest in your startup.

How do stock options work?

Let’s walk through the process of how stock options work. You hire an employee. As part of the benefits package, you grant 100 stock options. These options will vest after four years.

Once the employee has worked for you for this period, she can exercise these stock options. She buys the shares at the strike price, which was set when the options were granted.

If your company goes public, employees can sell their shares for a profit.

Startup stock options are typically granted as part of a stock option plan, which outlines the rules for how employees earn and exercise their options. Let’s dive deeper into each step of issuing stock options.

1. Granting stock options

When first hired, employees receive an offer to purchase a set number of shares of the company at a predetermined price, known as the strike price or exercise price. This price is usually based on the company’s fair market value at the time of the stock option grant.

The fair market value of your startup can be calculated in a few ways, but the most common is a 409A valuation. This is an independent appraisal used to determine stock option pricing.

It’s not necessarily every employee who gets stock options. You, as the founder, can determine whether to offer them to all new hires or just to certain roles or employees of a certain seniority. And it’s up to you how many options to offer each employee. Generally, executives and founders have the most options, followed by early employees and mid-level employees. Junior and non-technical staff may receive fewer options or none at all.

2. Following the vesting schedule

A vesting schedule is a timeline that determines when employees can purchase stock options. Employees don’t get all their stock options immediately. Instead, vesting ensures they gradually earn the right to buy shares over time. A vesting schedule helps companies reward long-term commitment and protect against employees leaving too soon.

A common vesting schedule is four years with a one-year cliff. In other words, the first portion vests after a year, and the rest vests monthly or quarterly.

For example, let’s say your employee is granted 4,800 stock options. If there’s a one-year cliff, she won’t receive any until the end of the first year, at which point 1,200 options (25%) become available. The remaining 3,600 options vest evenly each month (100 per month) over the next three years.

3. Exercising options

Once vested, employees are free to exercise their stock options by purchasing shares at the predetermined strike price. This means they can buy company stock at a fixed cost, regardless of its current market value.

If the company’s stock value has increased since the options were granted, employees can purchase shares at a discount compared to the market price, allowing them to realize an immediate financial gain.

They can either hold onto the shares in hopes of further appreciation or sell them to secure a profit. However, exercising stock options involves certain risks, including potential declines in stock value and tax implications.

Proper timing and strategic planning can maximize the benefits of stock options as part of an overall compensation package.

4. An exit event (IPO or acquisition) occurs

When a company goes public through an initial public offering (IPO) or gets acquired by another firm, employees who own company shares can sell them at a profit.

In an IPO, the company’s shares become publicly traded on the stock market, often increasing in value if the business performs well and attracts investor interest. Employees who received stock options or equity grants as part of their compensation can then sell their shares, potentially seeing large financial gains.

Similarly, during an acquisition, the acquiring company may offer to buy out existing shares at a premium, providing employees with a lucrative exit opportunity.

The exact financial benefits depend on the acquisition terms, such as whether the deal is structured as a cash buyout or a stock exchange.

In both cases, employees who hold equity in the company can capitalize on its success, making stock ownership a valuable incentive in startup and corporate compensation packages.

Why are stock options essential for startups?

Startups often can't match big tech salaries, so stock options are a cost-effective way to help startups recruit skilled professionals who believe in the company’s vision and keep them there as shares vest over time.

For instance, when Airbnb was getting started, they used stock options to attract top talent as they couldn’t necessarily afford sky-high salaries. This strategy built a committed team, and when the company went public, early employees who held their options saw significant financial gains. In fact, on the day of the IPO, shares more than doubled, boosting the valuation to over $100 billion in 2020.

Take inspiration from Airbnb’s approach. Offering equity as a key incentive for early hires, especially when you don’t have the budget to offer competitive salaries, can help you appeal to top talent.

How to create a stock option plan for your startup

If you’re an early-stage startup founder thinking about creating a stock option plan, there are several steps you'll need to take to build that plan, each requiring careful planning and execution. Let’s explore each one.

1. Determine your equity pool size

First, decide how much of the company’s equity to allocate to stock options. Typical option pools range from 10% to 20% of total equity.

To determine the right pool size, consider your startup’s valuation, future hiring plans, and the competitive landscape for talent.

If your budget doesn’t allow you to pay top dollar for senior engineers, for example, you may want to offer a generous stock option as part of the benefits package. See what your competitors are offering to guide you in the process of deciding how much equity to offer as stock options.

2. Choose the right type of stock option

Next, choose the right type of stock option. Common choices include Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).

ISOs offer tax advantages for your employees: they don’t pay tax when they exercise options, and if they hold the shares for two or more years from the grant date, they’ll pay only the long-term capital gains rate. However, they are limited to employees.

NSOs, on the other hand, provide more flexibility in who can use them. With NSOs, there’s no specific holding period to qualify for a particular tax treatment. And they can be granted to advisors and contractors.

RSAs, as we mentioned before, are ideal for early-stage startups when the company's valuation is very low. Employees can acquire these shares with minimal tax consequences.

You can also choose to offer a mix of stock options based on different criteria for employees. Choosing the right mix of these options ensures your stock option plan aligns with company goals, talent acquisition strategies, and long-term financial planning.

3. Design a vesting schedule

A well-structured vesting period ensures employees earn their equity over time, incentivizing long-term commitment. Most startups use a four-year vesting schedule with a one-year cliff—employees must stay for at least a year before earning any stock.

When you issue stock as part of a job offer, clearly outline the vesting period in the offer letter and stock option agreement. This sets expectations and reduces disputes. Additionally, define an expiration date, usually 10 years from the grant date, after which unexercised options become void.

For the C-suite, consider tying vesting to a liquidity event, like an acquisition or IPO. This ensures that employees are rewarded when the company succeeds.

4. Create legal documentation

Next, draft stock option agreements that outline exercise price, vesting terms, and expiration. Hire an independent third party to conduct a 409A valuation, which determines the fair market value (FMV) of your startup. It may take two to four weeks to complete, so plan the timing accordingly.

Keep cap tables updated whenever you issue or exercise stock options. There are cap table management tools such as Carta or Pulley that can help you manage them.

5. Communicate the plan to employees

Finally, communicate the plan to employees once it’s ready. Share a detailed stock options guide and hold an employee education session, delving into the value and mechanics of stock options, grants, vesting schedules, and tax implications. Maintain transparency about potential dilution and liquidity events.

Common mistakes to avoid when offering stock options

A poorly managed startup stock option plan can lead to legal, financial, and retention issues. Avoid these key mistakes to ensure a fair and effective equity program:

Over-promising equity during negotiations

One of the biggest mistakes startups make is not properly explaining dilution. As the company raises funding and issues more shares, existing ownership percentages decrease. Employees may not fully understand how dilution affects their equity, leading to frustration when their stake is smaller than expected. To avoid this:

• Provide a clear equity breakdown: Show employees how their percentage ownership could change over time with potential funding rounds.
• Use equity calculators: Offer tools that help employees visualize how dilution impacts their stake.
• Discuss liquidity events: Explain how stock options convert into financial gains, emphasizing that the value depends on company performance and future funding rounds.
• Be transparent in offer letters: Clearly outline how many shares employees receive, potential dilution scenarios, and what that means in real terms.

Neglecting tax implications for employees and the company

Failing to consider the tax treatment of startup stock options can also create unexpected financial burdens for both employees and the company.

Different types of stock options, such as Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs), come with varying tax consequences. A lack of clarity can lead to costly mistakes.

Employees may not realize that exercising stock options can trigger immediate tax liabilities. For example, NSOs are taxed as ordinary income upon exercise, while ISO holders may have to pay capital gains tax when selling shares. And employees exercising ISOs may be subject to Alternative Minimum Tax (AMT), a tax many do not anticipate.

Realize that your startup, too, will have to navigate tax obligations and reporting requirements. The company can deduct compensation expenses related to NSOs, but not ISOs, unless they are disqualified from favorable tax treatment.

Also, startups must properly withhold taxes on NSO exercises and report stock-based compensation on employee W-2s or 1099s.

To prevent tax-related surprises:

• Provide employees with clear documentation on the tax treatment of their stock options.
• Encourage employees to consult a financial advisor before exercising options.
• Stay compliant with 409A valuations to ensure options are granted at fair market value.

By proactively addressing tax considerations, startups can prevent misunderstandings, reduce legal risks, and ensure employees fully benefit from their stock option grants.

Failing to update employees on equity plan changes

A stock option plan is not static. It evolves as a startup grows, raises funding, and adjusts its equity strategy. Failing to update and communicate changes to employees can lead to confusion, frustration, and even legal disputes.

To ensure clear communication, hold annual or semi-annual meetings to discuss changes to the equity plan, upcoming funding rounds, and potential impacts on startup employees. Provide updated option agreements, summary sheets, and FAQs whenever adjustments are made.

Simplify the financial management of your startup with Digits

Startup stock options are a powerful tool for attracting and retaining top talent while aligning employee incentives with company growth. However, effectively managing an equity compensation plan requires careful financial planning, accurate record-keeping, and a clear understanding of the company's financial health. Without the right tools, founders may struggle to determine how much equity to allocate and whether a stock option plan makes sense for their business.

Digits simplifies this process by providing real-time financial insights, automated bookkeeping, and AI-powered transaction tracking. With its intuitive dashboards and precise financial reporting, founders can assess their startup’s financial position, evaluate the impact of stock options on their cap table, and make data-driven decisions about offering equity.

Take control of your startup’s finances with ease. Try Digits for free and see how an AI-native accounting platform can help you build a sustainable and scalable business.