November 16, 2022
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Kaisa Luht

How to Explain Stock Options to Your Employees?

Hiring employees is something that every startup founder has to do at some point in their journey. As the team grows, it is important to make your employees part of the success and give them stock options. 

If you’re a first-time founder, it can be challenging to fully understand the value of giving out stock options to your team members. It can be even harder to explain what stock options are and why they are important to your employees.

So, what are the ways to explain stock options to your team members?

Follow along as we deep dive into this topic and tell you all about the importance of understanding stock options and explaining it in a simplistic manner.

Why Is It Important for Employees to Understand Stock Options?

Let’s assume you have decided to share the future value of your company with your employees and have set up a stock options plan. It was a complicated process, and you’re unsure how to sell this amazing benefit to attract the finest candidates.

The best place to start is figuring out why you wanted to offer it in the first place. Let’s have a look at some possibilities:

  • Because you feel it is fair to share the future value of the company with the people who helped build it.
  • Because you want to make employees rich.
  • Because all other startups are doing it.
  • Because you have put a lot of thought into your reward strategy and believe it is the best long-term incentive to help you attract, retain and motivate employees. 

Suppose you want to give out stock options because you wish to share the value of your company. In that case, it is important for your employees to know how to cash it and what their obligations are. Those can be details like when to exercise, when to sell, and when to pay the tax. If they are unaware of these details, they could lose all of their options or end up with high tax liabilities.

If you want to give out stock options because it is a large part of your reward strategy, you need to educate your employees about that. It is important they understand why options are so beneficial to them  for it to be an effective motivational tool.

How and When to Talk About Stock Options?

Your basic assumption should be that candidates and employees know nothing about stock options. Your communication should be with as simple and short sentences as possible. Visuals also help – diagrams, slides, or videos. You choose.

It is important that you already talk about this benefit during the hiring process. You should not only mention how many options the candidate will get but also what they are and why the hire should be excited about receiving them. 

Include some terms of the grant in your offer letter – how many options, how many years is the vesting plan, and is there a cliff. We would also suggest adding a link in the offer letter to additional resources that can explain the terms you use.

During the onboarding process, you can remind them of the perk again. You can do it either by chatting, sharing materials, or having someone do an educational class. 

The latter makes sense once your onboarding groups are already bigger than just a few people.

It also doesn’t hurt to remind employees of stock options every year by doing live Q&As where they can ask questions they might have on this topic.

Things to Say to Your Employee

What Are Stock Options?

Stock Options are a legal promise. With them, you can become a shareholder or get extra cash. 

Imagine that a share in a company is like one slice of cake, where all slices are equal but very thin. A stock option allows you to buy a slice of that cake at an agreed price and sell it for profit.

What Are Stock Options Good For?

Stock options allow people to share the value of the company. You help make the company a success with your work, and later you can make cash by selling a piece of it.

What Are Stock Options Worth?

Until something is done with the stock options, they aren’t worth anything. They are just a legal promise. Once there is the possibility to sell them, one option is worth as much as one share in the company. 

It is very hard to determine the value of a stock option before the company goes public. To illustrate the worth of an option, you can show the employee how much investors have been willing to pay for a share in the past. 

But do stress that just like with any shares, the price can go up or down. There are no guarantees.

What Is Vesting and How Does It Work?

Vesting is like earning something over a period of time. 

Let’s say you are offered 100 options over 4 years. This means that after the first year, you will have the right to 25 options, after two years to 50 options, and by the end of 4 years, you have earned the right to buy and sell all 100 options.

What Is a Cliff?

Usually, there is a one-year cliff with the vesting schedule. This means that before your first-year anniversary, none of the options will vest. 

It is important to know this because if you leave before your 1st year, you won’t have any options. On your first year anniversary, all the options for the first year vest at once, like a birthday present.

What Happens When the Employment Contract Is Terminated?

This depends on the company’s ESOP plan. There are roughly three possible possibilities: 

  1. Your employee gets to keep the vested options and doesn’t have to do anything with them until there is a possibility of selling them.
  2. Your employee has to buy them out and become a shareholder, or they lose the right to the options.
  3. Your employee is considered a bad leaver and will lose all the options.

When Can Stock Options Be Cashed Out?

This is the number one question on the employee’s mind. They want to know when they can actually see the benefit of this perk.

Most companies don’t have a clear-cut answer to this question. The possibility of selling shares is organised ad hoc (if at all), and no one really knows when a company will go public. Or even if they do, it is usually highly confidential data until the event has happened. 

So all you can tell your candidate is that they will get money from the vested stock options once there is a possibility to sell them.

Are Stock Options Taxed?

This usually comes as a surprise, but yes, they are. Each country has its own rules as to how they are taxed. 

Generally, the taxes that have to be paid are either employment taxes or capital gains taxes.

As a company, you need to know if the employee will be fully responsible for paying the taxes on the stock options or if the company also has a duty to withhold tax.

In a Nutshell

It does not matter how good your stock option plan is if your employees do not understand it. You should take time and explain it to them. If you do not invest in this topic, then your most treasured benefit – ownership in the company – will not be appreciated. 

In that case, the employees will simply lose their stock options or have tax liabilities that they are not aware of.

In order to avoid that, we have a couple of suggestions for you:

Things to Do:

  • Discuss stock options already during the hiring.
  • Give details of the stock grant in the offer letter.
  • Give links to extra resources with the offer letter.
  • Communicate the company offering again and in more detail during onboarding.
  • Do live Q&As about stock options.
  • Keep it simple.

Things Not to Do:

  • Expect employees to know what stock options are.
  • Give a stock option agreement and not explain what it is or how it works.
  • Oversell the value of stock options.

Here at Salto X, we help founders create and manage their company’s incentive program for their remote teams. We believe sharing a company’s upside should be easier and more transparent for everybody involved. 

Interested in hearing more? We’d love to jump on a call with you for further discussion.