How do startups adapt stock option strategies as valuations grow?

The goal of stock options is to enable employees to participate in your company’s growth. However, outdated stock option plans create problems for employees as well as other key stakeholders.

Underwhelming stock option plans lead to disengagement and turnover. On the other hand, outdated plans can seem overly generous and go against the interests of other stakeholders and can lead to higher-than-expected dilution without substantial capital infusion.

6 key strategies to keep your stock option plans effective!

Use the following six strategies to keep your stock option plans effective for attracting and retaining talent while balancing the interests of other stakeholders.

Reevaluate the option pool size

As your company’s valuation grows, so will its workforce. Gradually, the original employee stock option pool will become inadequate. To ensure that stock-based compensation holds value for employees, you could limit its distribution only to senior employees. However, your ability to attract and retain new employees will then decline.

On the other hand, spreading the same option pool across a larger workforce would reduce the value received by each employee. Also, certain tax benefits might be lost when you make significant changes to your plans. So, you must periodically review the size of your employee stock option pool and make adjustments.

If your startup is issuing stock options through an Employee Stock Purchase Plan (ESPP), the size of your option pool plays a key role in tax compliance. One of the key requirements in such plans is that new employees must opt in or opt out within a certain period after joining.

If your option pool is inadequate when you go on a hiring spree in an attempt to scale operations, you would have to urgently propose a resizing of your option pool to the board for approval. Then, if your board doesn’t approve the resizing in time, it would delay the injection of new talent.

Adjust strike prices

When your company’s valuation grows, the gap between your exercise price and stock price will increase. At startups, this gap widens faster than it does at established corporations.

On one hand, this makes your stock-based compensation more attractive. On the other hand, it also reduces your ability to retain employees. Let us explore why this happens through an example.

Suppose you have been issuing stock option plans to employees for the past two years at an exercise price of $5. Presently, your stock price stands at $100. Then, your employees would want to exercise vested options and sell their stakes as soon as possible. After all, they cannot predict changes to this wide gap between the exercise price and stock price. If this gap narrows, the opportunity will be lost. Since the perceived value of future stock-based compensation is low, they would be more open to job offers.

Investors might also push back when there is a wide gap between the exercise price and the stock price. They may argue that the stock options are excessively generous and cause more dilution than can be tolerated. Additionally, if you are issuing incentive stock options (ISOs), you must issue them at exercise prices equal to or more than the fair market value on the date of the grant. In such cases, you must constantly update the exercise prices as your valuation changes.

Grant new stock options

To ensure that everyone is familiar with stock option plans, as senior employees leverage the potential of these options and remain tax-compliant, it is essential to educate your new employees on stock-based compensation.

As part of your orientation program, include a presentation on the type of stock-based compensation you issue, its benefits, and the tax considerations. Since the tax considerations can be complex, you should open the floor to questions. By maintaining an accessible online resource for understanding tax implications and potential benefits, as well as preparing various relevant forms.

By sharing valuation updates regularly, you can build trust through transparency and sustain enthusiasm as valuations rise.

Reinvest in employee education

To ensure that new employees are familiar with stock options as senior employees, you need to educate them on stock-based compensation and how to leverage the potential of each. This is especially true if you issue complex or lesser-known forms of stock-based compensation such as phantom stocks, stock appreciation rights (SARs), and restricted stock units (RSUs).

Tax considerations can be complex, and management must be ready to address any queries. Maintaining an accessible online resource for understanding tax implications and gains is also helpful. You must also communicate changes in stock option plans with agility, so that employees have sufficient time to reassess their strategies and ensure tax compliance.

By sharing valuation updates regularly, you can build trust through transparency and sustain enthusiasm as valuations rise.

Explore different types of equity compensation

At inception, most startups outsource various processes under the supervision of high-ranking employees. Junior employees are typically hired later once the startup has scaled its operations and aims to consolidate expenses through the internalization of processes.

A high-ranking employee is likely to have larger cash reserves than their juniors and would find stock options accessible. They can easily pay the exercise price more than junior employees. Those who are less accessible would prefer Stock Appreciation Rights (SARs) that do not require the payment of the exercise price. This is a stock-based compensation that provides the capital gains benefit to the receiver without actually granting shares.

Startups may need to improve their stock-based compensation packages to attract and retain leadership talent, especially at scale operations, and your focus shifts from maintaining a market presence. At times, you may not be able to attract talent through ISOs; you may need to offer non-qualified stock options (NSOs) that have lower exercise price than the FMV. Thus, NSOs would hold value for the receiver right from the grant date.

Plan for liquidity

If you are not planning an initial public offering (IPO) soon, employees may view their stock-based compensation as unattainable goals. To ensure that your employees see value in such compensation and don’t view it simply as a cash conservation tactic, you must facilitate exits.

The simplest, most direct exit you could provide would be buybacks. Last year, SpaceX and its investors issued a $1.25 billion offer to purchase shares from its employees and other shareholders.

However, this form of exit can deplete your startup’s cash reserves and is not recommended for those generating substantial revenue. You could also partner with a long-time investor to provide investment exits to your employees.

Another form of exit would involve requesting incoming investors in a funding round. This can be a viable option if a larger corporation is considering a strategic investment in your company. Such investors would appreciate the extra control that comes with the additional shares.

Seamless equity management with Eqvista!

Keeping track of equity-related changes can be challenging, even for seasoned venture capitalists. A startup issues various types of complex securities and needs to update its stock-based compensation plans in response to changes in valuation, employee needs, and regulations.

These changes have varying effects on dilution, expected returns, and risk. Hence, an equity management platform, such as Eqvista, is essential to help employees visualize changes to stock option strategies.

We can be assured data privacy by controlling access levels seamlessly and enable you to be as transparent without divulging sensitive information. Contact us for a demonstration!

Disclaimer: Since tax laws and regulations can vary from state to state, it is prudent to consult a taxation expert before making any changes to stock-based compensation plans.