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Why companies give early employees options to "buy" stocks? Why can't they just be granted once vested and be done?

wpietri 12y ago
Taxes, mainly. If you are very early, when the company is worth nothing, then the company can give you a big chunk of stock with no tax consequences. But once the company is worth something, then getting the stock is income, and you have to pay taxes immediately on the market value. It's not as good from the company tax perspective, either. It's also a problem in that if the stock is already valuable, giving you the stock is the wrong reward structure. Companies are giving you options so that you have an interest in the stock going up. Suppose when you show up the share value is $40 and they give you 1,000 shares. if while you're there the stock goes up to $60, you will have received something worth $60,000, even though you only contributed to creating $20,000 of that. With options, they can give you 3,000 options with a strike price of $40. If the stock goes up to $60, then you still make $60,000 ($20 gain * 3000 options). But if it doesn't go up at all, then your options would be worthless.
- dlubarov 12y ago
  > you only contributed to creating $20,000 of that That's an interesting way to think about it, but as long as the employee is getting a base salary, the employer couldn't justify granting enough options to achieve this goal of compensation being equal to (theoretical) value added. If we consider base salary fixed, then options are more leveraged, but a similar reward structure could be achieved by granting the same number of RSUs and reducing base salary by the exercise cost.
  - wpietri 12y ago
    Sorry, I didn't mean to suggest that the goal was for compensation to be equal to value added. I think the goal is for it to be proportional, or at least more proportional than a pure stock grant would be.
corysama 12y ago
If you receive a nice grant of stock from your company, it will probably be few years before you want to sell that stock for cash. In fact, it will likely be several years before there is a reasonable way to sell the stock even if you wanted to. Selling stock in a privately-held, early-stage startup is often not a simple matter. Despite that, the US IRS will want you to pay taxes on the current value of that stock in cash this year. The IRS doesn't care that you don't have the cash. And, they don't care that there's a very large chance the stock will turn worthless before you can sell it for cash. Options however are not taxed until they are exercised. In practice, exercised options are usually converted directly to cash. That makes paying the taxes much easier. And, if the company folds you get nothing, but at least you didn't pay taxes up front on a stock that turned worthless. So, it's a bit complicated, but options are usually more friendly to employees than direct grants in general. Details in the options like "What happens to my options if I leave the company?" are important. They can also be complicated and possibly employee unfriendly. I'll leave the discussion of that detail to the rest of the crew here.

Taxes, mainly. If you are very early, when the company is worth nothing, then the company can give you a big chunk of stock with no tax consequences. But once the company is worth something, then getting the stock is income, and you have to pay taxes immediately on the market value. It's not as good from the company tax perspective, either. It's also a problem in that if the stock is already valuable, giving you the stock is the wrong reward structure. Companies are giving you options so that you have an interest in the stock going up. Suppose when you show up the share value is $40 and they give you 1,000 shares. if while you're there the stock goes up to $60, you will have received something worth $60,000, even though you only contributed to creating $20,000 of that. With options, they can give you 3,000 options with a strike price of $40. If the stock goes up to $60, then you still make $60,000 ($20 gain * 3000 options). But if it doesn't go up at all, then your options would be worthless.

dlubarov 12y ago
> you only contributed to creating $20,000 of that That's an interesting way to think about it, but as long as the employee is getting a base salary, the employer couldn't justify granting enough options to achieve this goal of compensation being equal to (theoretical) value added. If we consider base salary fixed, then options are more leveraged, but a similar reward structure could be achieved by granting the same number of RSUs and reducing base salary by the exercise cost.
- wpietri 12y ago
  Sorry, I didn't mean to suggest that the goal was for compensation to be equal to value added. I think the goal is for it to be proportional, or at least more proportional than a pure stock grant would be.

corysama 12y ago

If you receive a nice grant of stock from your company, it will probably be few years before you want to sell that stock for cash. In fact, it will likely be several years before there is a reasonable way to sell the stock even if you wanted to. Selling stock in a privately-held, early-stage startup is often not a simple matter. Despite that, the US IRS will want you to pay taxes on the current value of that stock in cash this year. The IRS doesn't care that you don't have the cash. And, they don't care that there's a very large chance the stock will turn worthless before you can sell it for cash. Options however are not taxed until they are exercised. In practice, exercised options are usually converted directly to cash. That makes paying the taxes much easier. And, if the company folds you get nothing, but at least you didn't pay taxes up front on a stock that turned worthless. So, it's a bit complicated, but options are usually more friendly to employees than direct grants in general. Details in the options like "What happens to my options if I leave the company?" are important. They can also be complicated and possibly employee unfriendly. I'll leave the discussion of that detail to the rest of the crew here.