A growing number of startups are offering employee stock options to attract superior talent to join their teams. This is a form of equity compensation that allows employees to have a larger stake in the business and explore leadership roles in the future. It helps startups compete in a job market where they can only offer limited compensation yet need to develop a competitive edge during recruitment.
The prospect of owning equity in the business is a recruitment and retention strategy for companies. It can be a win-win, especially if an employee becomes a valuable and long-standing team member. But how are these stock options impacted when an employee leaves the company prematurely or after the options are exercised? Typically, it depends upon the circumstances in which the employee leaves.
Let’s understand each of them in depth.
3 common employee exit scenarios
Employees may leave an organization in different circumstances. The value and ownership status of the stock options will depend upon the following factors:
- Did the employee leave the company before the vesting period was complete and no stock option grant rights were exercised?
- Did the employee leave during the vesting period but has been granted partial exercise rights?
- Did the employee leave after the vesting period was over, and their stock options have been thoroughly exercised?
To understand the implications of the scenarios, it is first important to understand the meaning of vesting period and exercising stock options.
What is a vesting period?
This is a predetermined time frame during which the employee must meet certain conditions before purchasing the stock options at a fixed price.
For instance, the employee may be required to stay with the company for a specific number of years before the ownership of stock options is transferred to them. They may also be required to achieve certain milestones or targets during the vesting period.
Once the vesting period is complete, and all the conditions have been successfully met, the employee is granted ownership of the stock options. The contract may require them to purchase the stock options at a fixed price lower than the fair market price, or the market price if the company is already publicly listed.
Alternatively, the company may grant them the stock options without having to purchase them or stagger the granting of ownership in phases.
Exercising of stock options explained
This is the process of purchasing the organization’s stock at the predetermined price, known as the grant price, irrespective of the stock price at the time when the stock option is exercised. As per the contract, the stock option may be exercised all at once after a fixed period or in stages based on the employee’s ability to satisfy all or at least some of the conditions.
For instance, the stock options contract may state that an employee may exercise 50% of the options after two years and 100% after four years. The employee will be able to exercise ownership rights of the stock options based on the terms of the contract. Companies can set the conditions based on their specific recruitment and retention goals.
Impact of the 3 exit scenarios on stock ownership
Here is a closer look at three potential outcomes when an employee leaves the company:
1.Exit without exercising stock options
Employees who leave the organization before completing the vesting period forfeit the right to own any stock. Even if the contract offers a partial vesting option, and they do not complete any of the conditions, they still forfeit the rights to own the stock. Typically employees who leave within a year face this scenario.
2.Exit with partial exercising of stock options
A company may also choose to stagger granting of ownership and may decide to do it annually.
For instance, suppose a company’s contract allows employees to exercise 20 % of ownership rights annually. If the employee leaves within three years, then they will have exercised 60% of the stock ownership when they leave. Hence, they only forfeit 40% of the stock while adding 60 % to their investment portfolio.
3.Exit after exercising stock options
Employees who leave after the vesting period is over can exercise 100% of their stock ownership rights. However, one must be cautious of the time frame within which the rights must be exercised after departure from the company. Companies also can buy back the stock at the Fair Market Price, which enables the employee to make a profit once the rights are exercised.
However, if they choose to retain ownership, this stock becomes part of their investment portfolio, which they can sell on the market once the company is publicly traded. Their profit or loss will depend on the market value of the stock at the time when they sell the stock.
Offering stock options is an effective strategy for companies and startups to attract the best talent in the market, specifically in unique, highly-skilled roles. Potential employees are looking for a higher stake in the business and the potential to grow with the company, and they see it as a lucrative wealth-creation instrument.
However, companies must frame their stock options contracts cautiously. Factors such as the vesting period, the conditions or targets to be satisfied, and the exercising rights schedule, must be strategically set to benefit the company and serve as an effective incentive for the employee.
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