Spotlight: The Inside Story of Startup Stock Options

Last week after months, actually years, of work we formally announced our Tadaweb Stock options scheme to the team. If you are reading this from the Valley, or the States in general, you may question why I decided to dedicate a whole blog to this theme... "uhhh... startups, stock options isn't that a given?" you may be pondering. However, in Europe, particularly in Luxembourg - stock options in young companies are rare and very very difficult to implement, for a number of reasons that I will mention later. But despite these, which if I am an honest turned into a nice tennis match between our amazing legal team from Arendt, our shareholders and us as founders, we didn't give up on the promise we have been making with our employees for the last 5 years.... In response, I wanted to use this blog to share our experience, to encourage other young European companies, in Luxembourg and beyond, to understand not only how stock options work, but also the advantages they create for a company...

A little history...

As founders, we were fortunate to hit the Silicon Valley early, before even reaching our first birthday we had pitched on the stage of TechCrunch Disrupt in San Francisco and had hit the press in TechCrunch... We visited Google, Twitter and Facebook and had awesome advisors from the States early on. From very early, we got in tune with that mindset, both with regard to culture, but also risk taking and of course, the idea of stock options.

I remember coming back to Europe buzzing with all I had learnt, eager and willing to replicate so many aspects of what I had witnessed, including of course allocating my growing team some Tada stock so it wasn't just "them" they we working "for", it was "us" they were working "with". However, to my surprise, or rather as a result of my naivety - a stock options scheme wasn't an "out of the box" solution to implement, as I was to find out - far from it... So here I will start from the beginning... as in the very beginning... as in "what is a stock option?" And as a disclaimer - sure, I studied law, but I am no legal expert particularly with regard to corporate law in Luxembourg... So I have chosen to explain terms in my own words, in language I understand - with the hope that you will to.

First things first. The "stock option"

A stock option is basically an "option to buy stock" when an agreed events occurs. Fancy that, a stock option just means an option to by stock? See it's not rocket science yet.

However, where things start to get a little complicated is when deciding upon the many different components that make up a stock options scheme (the agreement that employees sign with the company) a few issues rise to the surface. The main issue for us was all about tax... woooo, tax. Here in Luxembourg, it is often the case that employees must pay tax upfront, as soon as the options were allocated. As founders, we weren't ok with this as we wanted to ensure our employees had "free access" to their options, however I will get more into that delightful subject later. Next...

We got our awesome legal team from Arendt to come into our office and directly explain everything to our company, while also answering ANY questions the team had about any aspect of the stock options scheme.

The "Conditions of Conversion"

So if you are following so far, you should be starting to understand that exercising the options is where the fun happens, it's the "cash out time." This is essentially when your "option to have stock" converts into "actual stock" which you can or may be forced to sell. Therefore, the conditions of conversion are very important to understand and decide upon as shareholders and founders. The conversion is often customised to the company, but often includes such factors as: the sale of the company, the disposal of all or most of the assets of the company, an IPO or potential buy backs. But.. you may be thinking, how much will I have to pay to have access to my options?

The "Strike Price"

Well, great you asked. Introducing: the strike price - No, it has nothing to do with baseball or irons. Rather, the strike price is the price to be paid by the beneficiary (in our case, employee) at conversion of the stock options (i.e. exit or IPO) and is based on the price of the shares at the date of the allocation... The price is based on a fair market value at the time of allocation and therefore may not be the same for all employees... With me? No? Here is an example then (don't worry, it too me a while too)

Bob pays $100 to buy an option priced at $1 on Gorilla Airlines shares, with a strike price of $50. The option expires in two years. That means that any time in the next two years that Bob can exercise his option to buy 100 shares at $50 regardless, of the current market price of Gorilla airlines shares.

The "Vesting Period"

Vesting essentially provides the employer with protection against an employee obtaining stock options then leaving immediately afterwards, aka it ensures they stick around. Vesting phases achieve this through providing access to the stock options in portions, for example an employee may receive 25% of their allocated option per year with a total vesting period of four years. Some companies vest a long time, while others a shorter time frame. If you are an employee it is important to ask about something called "accelerated vesting" - this basically means that if you start a company and directly one year or so later, it IPO's, you may have the option to speed up at least a partial amount of your stock options that you haven't had the chance to formally vest. Also... some sneaky large companies place the largest percentage of the stock in the last year of vesting, for example 15%, 25%, 25%, 35% , however this is only usually occurs in the case of acquisitions, when the acquiring company needs to ensure the critical talent remains at least until the transition period is over.

Ok... so in a nutshell - shareholders of company decide to create a pool of stock dedicated purely to key actors (beneficiaries) - employees, advisors etc. The beneficiaries do not (often) receive all of the options up front, rather, they are vested over a number of years. Once a liquidity event occurs, that triggers the conversion, the options may then be purchased by the beneficiary at the strike price agreed upon on allocation.... All in all, when a company sells, IPOs or undergoes some other kind of "liquidity event" - employees get to cash in their piece of the pie!

Ok... That is the legal stuff, but what are the psychological advantages of stock options?

Trust me, shareholders don't go screaming to dilute in order to create a pool of stock for nothing.. nor do founders beg to spend months (in the case of Lux) implementing complicated legal documents for no good reason. For me personally, stock options play a critical roll across multiple areas.

1. Employees are driven to make it a success

Taking it from personal experience, I have never worked harder in my life than when it was for my own company. When key employees feel as though they own, even a small part, of the entity they are working for, they are much more driven to see it succeed - after all, it's success has direct implications on the value of their options.

2. It motivates top talent to stay

Earlier, I explained the notion of "vesting" - the process in which options are allocated over a period of time, usually around 25% per year for 4 years. When option holders see the value that their options possess or have the potential to possess, they are highly motivated to stick around and finish their vesting period.

3. They are motivated to create value

We have a rule at Tada, "hire people smarter than yourself." This can be extremely tough to do, as humans it's normal to be scared that we will be replaced or lose place in the pecking order by embarking on this type of strategy. However, when the managers understand that this strategy brings value to many different areas of the company, the are far more driven to embrace it. After all, the more valuable, talented and successful the company is, the better it is for the option holders.

4. The package deal

Lastly, as is often the case in startups, offering massive salaries can be tough... At Tada, we like to offer our potential hires a solid "package" of goodies, that often include lunch vouchers, relocation, gym memberships etc. We often also add stock options and take potential recruits through the simulation of how much value they have the potential of becoming. This has helped us a lot in the earlier days when trying to bring in rockstars.

So all in all. Yes, it can be tough pioneering things such as stock options in places like Europe. But it is not impossible and has many key advantages for both companies and their key talent. Just make sure you get the right people on board, have shareholders that agree with the strategy and understand exactly how they work! Good luck.