If you are an employee in a company and have been offered equity compensation, then it is time for you to learn all your options. It is important for you to know how the stock options will benefit you, how it works, and what laws are there for it.
To begin, stock options are not just a benefit for you but also for your employer. And even though stock options are usually given to the senior executives in a company, every kind of employee is eligible for it. So, if you create your own value in the company, or if you have already done so, you have or will get stock options from the owner as compensation for your services.
Why offering Employee Stock?
As mentioned above, stock options are an offering made by the company which allows employees to purchase a certain number of shares in the company at a predefined price and date. It is not a must for the employee to buy any or all of the shares offered, and they can buy anytime and as many as they want between the offer date and expiration date.
Here are some reasons as to why you should offer stock options to your employees:
1. Attract & Keep Skilled Employees
A lot of companies out there know the pain of attracting and retaining the best talents in the industry. Just as successful sports teams attract experienced players from other teams or must “grow” their own talent, employers have to follow the same path. In fact, even in a down economy, you can easily get the best talent in the industry if you offer them something better than what the other companies are offering. And the answer to this is – stock options. Offering meaningful stock options both attracts better, more talented employees and helps keep them for the long term.
2. Model More Dedicated Employees
It is common to see many employers trying their best to motivate their employees and generate loyalty. But not all turn out to be successful in their venture. The main reason is that they are maybe not using the right way to motivate their employees. Offering employees with stock options would surely help in not just motivating them but also in increasing the productivity in the company.
To explain better, when an employee exercises their stock options, they usually become more committed to a company’s success. Their stock value hinges on company performance, which, of course, is a direct by-product of employee achievement. Historically, stock options create motivation and dedication for all employees involved as they are more invested in the company and its results.
3. Cost-Effective Company Benefit
These days, companies have to spend a lot on offering benefits to their employees. And due to this, companies are expanding their search for programs that offer high value for a moderate cost. That is where stock options come in. Stock option plans act as a great benefit for employees and are also highly cost-effective for companies.
While stock options are seldom substitutes for compensation increases, as part of a solid benefits program, they help make employment packages more attractive. The only costs issues that the company would incur is the lost opportunities for selling the same stock at market value as the employees pay a discounted price on the shares, plus administration costs. In short, the cost-effectiveness allows small companies to compete with large corporations.
Two Common Types of Employee Equity
When it comes to employee equity, there are two types of stock you should understand well enough to describe to your early employees, including preferred stock and common stock. Each has been explained below for you to understand the difference between them:
1. Common Stock
Common stock is normally used for employees as it does not have any additional rights or liquidation preferences. It is seen as less valuable (when the company is still private) and it’s priced at a discount to preferred stock.
2. Prefered Stock
Preferred stock is the kind of shares that are sold to the investors of a company. They are known as “preferred” as they have some additional rights that come with them. These rights include voting on particular corporate governance matters and selecting the board members. This kind of share is also first in the line of payout in liquidation cases, and when a company goes public, preferred stock turns into common stock to make all everything as one kind that anyone can buy.
Understanding Vesting & Cliff
Granting stock options or restricted stock to employees means that you will have to give out installments over time. And when we talk about breaking down the grants into installments, two more concepts come into light, as below:
The first concept is vesting. Vesting is when an employee gains the right to exercise the stock. A vesting schedule lays out the timetable in which an employee gains the rights to the options. There are many kinds of vesting schedules, but linear vesting is common. It basically divides the same amount of stock vesting periodically — whether that’s every month, quarter, or year.
The second concept is the cliff. A cliff is a milestone when the first portion of the stock vests, meaning the employee does not get the rights to the options until the cliff. Most companies have a one-year cliff added to their vesting plans. Let us take an example to explain this.
Assume that Anthony is offered options by a company with a 4-year linear monthly vesting schedule which also has a 1-year cliff. In this case, Anthony will get the shares all together after 4 years, which is 48 months of being with the company. And since there is a 1-year cliff, he will have to wait for a year before he gets the first part of the shares, which would be 25% of the total number of shares granted.
Why are vesting schedules and cliffs important?
There are many reasons as to why vesting schedules and cliffs are important and help in following a standard pace:
- They incentivize people in making long-term investments in a company by rewarding them with equity over time.
- They make sure that the employee is a good fit for the company before they have a piece of it. In case the employee makes a decision to leave the company early, they would not go with the equity.
- They come in line with the growing contributions of a company with time. To explain better, options are offered to the employee at the beginning of the employment when they haven’t done anything for the company yet. Vesting makes sure that the equity commensurates with their time in the company.
Although vesting schedules and cliffs are used more for employee grants, they are also at times used for founders and investor grants as well. You just need to know when to add it to the plan so that you are safe from losing anything. Learn more about employee stock grants here!