I’ve seen it a hundred times. A founder, bright-eyed and ready to conquer the world. They’ve got a killer idea, a solid team, and a pitch deck that could make a VC weep with joy. But then we get to the topic of stock options, and their eyes glaze over. It’s like hitting a brick wall at 100 miles per hour.
And I get it. Stock options are complicated. They’re a messy cocktail of finance, law, and human psychology. It’s enough to make anyone’s head spin. But here’s the unvarnished truth: if you’re a startup founder, you can’t afford to be ignorant about them. They are one of the most powerful weapons in your arsenal for attracting and retaining top-tier talent.
I learned this the hard way, with plenty of scars to prove it. At my first company, RemoteTeam, we made a ton of rookie mistakes with our option plan. We were so heads-down building the product that we treated equity as an afterthought. We ended up with a plan that was a black box to our employees and a massive headache for us to manage. It wasn’t until we were deep in the trenches of our acquisition by Gusto that we truly understood the critical importance of getting this right from day one.
With my second company, MovieLaLa, we were determined not to repeat the same blunders. We invested significant time and money, working with top-tier lawyers and compensation experts to craft a plan that was fair, transparent, and dead simple to understand. And it paid off, big time. We were able to attract and retain some of the most brilliant engineers and designers in Silicon Valley, which was a major factor in our eventual acquisition by Gfycat.
So, to save you from the same painful lessons I learned, I’ve put together this no-BS guide to startup stock option plans. This is the guide I wish someone had handed me when I was just starting out.
What the Heck Are Stock Options, Anyway?
Let’s start from square one. A stock option is the right to buy a certain number of shares in a company at a predetermined price, known as the “strike price” or “exercise price.” The whole game is that as the company grows and becomes more valuable, the stock price will go up. So, if you have an option to buy a stock at $1 per share and the stock is now worth $10 per share, you’ve made a tidy 10x profit on paper.
For employees, stock options are a way to get a piece of the upside. They’re a powerful incentive to work their butts off and stay with the company for the long haul. For founders, they’re a way to attract and retain top talent without having to offer insane salaries that would bankrupt the company.
It’s a win-win, right? Well, not so fast. If you’re not careful, stock options can be a recipe for disaster. I’ve seen it happen. I’ve seen employees get screwed over by confusing and unfair option plans. I’ve seen founders get diluted to the point where they own a tiny fraction of the company they bled for. And I’ve seen companies get bogged down in legal and administrative nightmares that make you want to tear your hair out.
ISOs vs. NSOs: The Alphabet Soup of Stock Options
There are two main flavors of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). The difference is all in the taxes.
- ISOs are the gold standard for employees. They get favorable tax treatment. When an employee exercises their ISOs, they don’t have to pay any taxes. They only pay taxes when they sell the stock, and even then, it’s at the lower long-term capital gains rate (as long as they hold the stock for at least a year after exercising and two years after the grant date).
- NSOs are more flexible, but the tax situation is not as sweet. When an employee exercises their NSOs, they have to pay ordinary income tax on the difference between the strike price and the fair market value of the stock. It’s a big tax hit, and it can be a major problem for employees who don’t have the cash to pay the taxes.
As a founder, you should always try to issue ISOs to your employees. It’s a huge selling point, and it shows that you’re looking out for their best interests. NSOs are more common for contractors, advisors, and international employees.
The Four Horsemen of Stock Option Apocalypse: The Biggest Mistakes Founders Make
In my 200+ angel investments, I’ve seen every possible way a founder can screw up stock options. But they usually fall into one of four categories:
1. Not Having a Plan
This is the cardinal sin. A founder will hire a few employees and promise them some equity, but they won’t have a formal plan in place. They’ll just wing it. This is a recipe for disaster. Without a formal plan, there’s no way to ensure that everyone is being treated fairly. And when it comes time to raise money or sell the company, you’ll have a huge, tangled mess on your hands.
I remember one founder I talked to who had promised equity to a dozen different people, all with different terms. He had scribbled the details on the back of a napkin. When he went to raise his Series A, the VCs took one look at his cap table and ran for the hills. It took him six months and a team of expensive lawyers to clean up the mess. Don’t be that guy.
2. Having a Bad Plan
Almost as bad as not having a plan is having a bad plan. A bad plan is one that is confusing, unfair, or just plain stupid. I’ve seen plans with crazy vesting schedules, plans with no acceleration on a change of control, and plans with a strike price that was way too high.
A few years ago, I was advising a startup that had a plan with a five-year vesting schedule. That’s insane. The industry standard is four years. And to make matters worse, there was no cliff. So, if an employee left after a month, they would still get some stock. It was a total mess. The founders thought they were being clever, but they were just shooting themselves in the foot.
3. Not Communicating the Plan
Even if you have a great plan, it’s worthless if your employees don’t understand it. I’ve seen so many founders who just hand their employees a stack of legal documents and expect them to figure it out. That’s not going to work. You need to sit down with your employees and explain the plan to them in plain English. You need to make sure they understand how it works, what the risks are, and what the potential rewards are.
I’m a huge believer in radical transparency. At both of my companies, we held regular all-hands meetings where we would go over the financials and the stock option plan. We wanted to make sure that everyone felt like an owner, not just a cog in the machine.
4. Not Thinking About the Endgame
This is a subtle one, but it’s just as important as the others. A lot of founders don’t think about what will happen to their stock option plan when they sell the company or go public. They don’t have a clear plan for how options will be handled in a change of control. This can lead to a lot of confusion and anger down the road.
I’ve seen deals fall apart at the last minute because the founders and the acquirer couldn’t agree on how to handle the employee stock options. It’s a heartbreaking situation, and it’s one that can be easily avoided if you just think ahead.
How to Create a Stock Option Plan That Doesn’t Suck
So, how do you create a stock option plan that doesn’t suck? Here are a few tips:
1. Hire a Good Lawyer
This is not the time to be cheap. I know you’re a startup and you’re trying to save money, but this is one area where you can’t afford to cut corners. A good lawyer will help you navigate the complex legal and tax issues involved in setting up a stock option plan. They’ll also help you create a plan that is fair to both you and your employees.
I’ve worked with a lot of lawyers over the years, and I can tell you that they’re not all created equal. You want to find a lawyer who specializes in startups and has a lot of experience with stock option plans. Don’t be afraid to ask for references. And if a lawyer starts talking in a lot of legal jargon that you don’t understand, run away. Fast.
2. Keep It Simple
The best stock option plans are the ones that are easy to understand. Don’t try to get too clever. Stick to the industry standards. That means a four-year vesting schedule with a one-year cliff. It means a strike price that is set at the fair market value of the stock. And it means a plan that is easy to administer.
I’m a big fan of the KISS principle: Keep It Simple, Stupid. The more complicated you make your plan, the more likely it is that something will go wrong. And when things go wrong with stock options, they go wrong in a big way.
3. Be Fair
Your stock option plan should be fair to both you and your employees. That means you need to be generous with the number of options you grant, but you also need to be realistic. You can’t give away the whole company.
A good rule of thumb is to set aside 10-20% of your company’s stock for your employee option pool. This will give you enough equity to attract and retain top talent without diluting yourself too much. And when it comes to granting options to individual employees, be consistent. Don’t play favorites. Create a clear and objective system for determining how many options each employee gets.
4. Communicate, Communicate, Communicate
I can’t say this enough. You need to be constantly communicating with your employees about the stock option plan. You need to make sure they understand how it works, what the risks are, and what the potential rewards are.
I’m a big believer in transparency. At both of my companies, we held regular all-hands meetings where we would go over the financials and the stock option plan. We even gave our employees a simple spreadsheet that they could use to calculate the potential value of their options. We wanted to make sure that everyone felt like an owner.
The Nitty-Gritty Details
Okay, let’s get into the weeds a little bit. Here are a few of the nitty-gritty details that you need to get right:
- Vesting: This is the process of earning your options over time. The standard vesting schedule is four years with a one-year cliff. This means you don’t get any options until you’ve been with the company for a year. After that, you get 25% of your options, and then you get the rest in monthly or quarterly installments over the next three years.
- Acceleration: This is what happens to your options if the company is acquired. There are two types of acceleration: single trigger and double trigger. Single trigger means your options vest immediately if the company is acquired. Double trigger means your options only vest if the company is acquired AND you’re fired or your job is significantly changed.
- Exercise Window: This is the period of time you have to exercise your options after you leave the company. The standard exercise window is 90 days. This can be a major problem for employees who don’t have the cash to exercise their options. Some companies are starting to offer longer exercise windows, which is a great way to be more employee-friendly.
The Bottom Line
Stock options are a powerful tool, but they’re also a dangerous one. If you’re not careful, you can end up with a mess on your hands. But if you follow the tips in this guide, you can create a plan that is fair, transparent, and easy to understand. And that will give you a huge advantage in the war for talent.
I’ve seen it happen time and time again. The companies that get this right are the ones that succeed. The ones that don’t are the ones that fail.
So, don’t be one of the failures. Take the time to create a stock option plan that doesn’t suck. Your employees will thank you for it. And so will your investors. Now go out there and build something great.
Frequently Asked Questions
How often is this guide updated?
I revisit and update my guides regularly as I learn new things and as the market evolves. The core principles tend to stay stable, but specific tactics and tools get refreshed based on what's working right now.
Is this guide based on real experience?
Every recommendation in this guide comes from direct experience, either from building and selling my own companies, or from patterns I've observed across 200+ angel investments. I don't write about things I haven't personally tested.
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