Most startups offer equity participation in their company to people providing services to the company, whether as employees, consultants, advisors or otherwise (which we will call “service providers” in this article). We often get asked about the difference between the two most common forms of equity grants – stock and options. This article is intended to highlight some of the important differences between them.
Stock (typically common stock) is the most basic and commonly understood form of equity. The recipient becomes a stockholder in the company just like founders and other stockholders, has voting rights (assuming he or she gets a form of stock that has voting rights) and is otherwise a full-fledged stockholder. That stock is probably subject to vesting tied to continuous service to the company, which in the case of stock is sometimes called “reverse vesting” because it gives the company the right to reacquire unvested stock if the service terminates (this is similar to how stock issued to founders and early stockholders is set up). (As a side note, it is important to remember that the company must affirmatively reacquire the unvested stock at the end of the person’s service or they may keep the stock, depending on the terms of the vesting agreement.)
When a company issues stock to a service provider, the service provider recognizes taxable income equal to the fair market value of the stock received in excess of what he paid for it. So, if the advisor receives 10,000 shares worth $1.00 per share and did not pay anything for the stock (i.e., it was granted for free in exchange for the advisor’s services), the advisor will recognize taxable income equal to $10,000 in the year of grant. (Note, this assumes the advisor files an 83(b) election. A discussion of 83(b) elections is beyond the scope of this article (see our related article What is a “Section 83(b) election” and Why Should I File One?)) It is precisely this taxable income issue that leads many companies with valuable stock to issue….options.
An option is a right to acquire stock. It is not a grant of stock itself, just the right to buy a share of stock at some predefined price (the “exercise price”). People holding options are not stockholders, do not vote like stockholders, and are merely holders of a contractual right to acquire stock.
The tax law requirements around setting the exercise price for an option is complex and beyond the scope of this article, but the most common practice is to set the exercise price to be equal to the fair market value of a share of the type of stock that is issued if the option is exercised. For example, if the option is for common stock, the exercise price would be the fair market value of a share of common stock on the date the option is granted (which typically means the date the board approves the option).
Assuming the exercise price is at least equal to the fair market value of the stock, the option is not taxable to the recipient at grant. So if our hypothetical advisor above didn’t want the $10,000 of taxable income, he or she could ask for an option for 10,000 shares, which would have an exercise price of $1.00 per share. There is no tax at the time of grant in this situation, but there may be tax at the time of exercise of the option or later, depending on the type of option. Again, while it is beyond the scope of this article, the tax treatment of stock and options is vastly different, and can lead to very different results for the holder at the time the option or stock is disposed of (such as in an acquisition of the company).
If the advisor wants to exercise the option and acquire the stock, he or she can exercise the option and pay $10,000 (or some lesser amount to only exercise a part of the option), and then become a stockholder. So as you can see, the “price” of not having tax at the time of grant is that the advisor must pay the value of the exercise price, whereas stock granted for free gives that value (net of taxes) to the recipient.
Options will also have a vesting period like stock, but the vesting provisions work in the reverse. Typically an option only may be exercised after it vests. For example, if the option above for 10,000 shares is 50% vested, the advisor could pay $5,000 to acquire 5,000 shares. The advisor has now become a stockholder as to 5,000 shares, and those shares are fully vested.
Sometimes options permit “early exercise.” This means that the option can be exercised (and the underlying stock issued) before it vests. Sometimes people ask for this because they are sophisticated enough to understand the tax consequences and this works better for their own financial situation. Explaining the tax consequences is beyond the scope of this article, but upon an early exercise the person would hold unvested stock that has “reverse vesting” like the stock grant discussed above. Many lawyers discourage the early exercise feature for most employees because the tax treatment starts to get complex and mistakes can be harmful.
Another common source of confusion is whether stock or options are issued from an “option pool”, or not. It is helpful to think of an option pool not as a “thing” but rather a legal and tax framework for issuing stock and options. You do not need an “option pool” to issue stock and options from a corporate law perspective, but having an option pool set up gives you a framework for doing so in a more simple and efficient manner. After you receive funding, it does matter quite a bit from a dilution standpoint whether the grant comes from the option pool or not, and we may cover this in a future article. Another somewhat misleading misnomer is that people often refer to the pool as an “option pool” as I did above, but most modern plans allow for the issuance of stock or options out of the pool.
Disclaimer: this article only discusses US federal tax law in effect at the time it was written. Laws of the individual states, or other local or foreign tax laws may, and likely do, have different results. This discussion applies to US C-corporations, not S-corporations, LLCs or partnerships.
Learn more about share incentives for UK companies in Share Incentives for Employees of Private UK Companies.