I’ve been in the startup game for a long time. I’ve seen it all. Two of my own companies, RemoteTeam and MovieLaLa, were acquired. I’ve also been fortunate enough to be an angel investor in over 200 companies, including some you might have heard of like Anthropic, OpenAI, and Scale AI.
One of the most common questions I get from founders is about stock options. It’s a topic that can be incredibly confusing, and it’s easy to make mistakes that can have serious consequences down the road. I’ve seen it happen time and time again. That’s why I decided to write this guide. This is the guide I wish I had when I was starting out.
What are Stock Options, and Why Do They Matter?
Let’s start with the basics. A stock option is the right to buy a certain number of shares in your company at a predetermined price, called the “strike price.” The idea is that as the company grows and becomes more valuable, the stock price will go up. Your employees can then exercise their options, buy the stock at the lower strike price, and sell it for a profit.
Why is this so important for startups? Because we’re always short on cash. We can’t compete with the big guys when it comes to salary. So, we use stock options to attract and retain top talent. It’s a way to give our employees a piece of the pie and align their incentives with the company’s success. When the company wins, everyone wins.
But here’s the thing: a stock option plan is not just a recruiting tool. It’s a legal document with serious implications. You need to get it right.
The Nitty-Gritty: How to Set Up a Stock Option Plan
Setting up a stock option plan, or ESOP (Employee Stock Option Plan), involves a few key steps. Here’s a breakdown of what you need to do:
- Get Board Approval: The first step is to get your board of directors to approve the plan. This is a formal process that needs to be documented in your board meeting minutes.
- Determine the Size of the Option Pool: You need to decide how much equity you’re going to set aside for employees. A typical option pool for an early-stage startup is between 10% and 20% of the company’s total equity. I’ve seen founders go as high as 25%, but that’s rare. My advice is to start with a smaller pool and increase it as you grow.
- Choose the Right Type of Options: There are two main types of stock options: Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). ISOs have a more favorable tax treatment for employees, but they can only be granted to employees. NSOs can be granted to anyone, including contractors and advisors. Most startups use a mix of both.
- Set the Vesting Schedule: Vesting is the process by which an employee earns their options over time. A typical vesting schedule is four years with a one-year cliff. This means that the employee has to work for the company for at least one year before they can exercise any of their options. After the one-year cliff, the options vest on a monthly or quarterly basis.
- Determine the Strike Price: The strike price is the price at which your employees can buy the stock. The strike price is usually set at the fair market value of the stock on the date the options are granted. You’ll need to get a 409A valuation to determine the fair market value of your stock. Don’t try to do this yourself. Hire a professional.
Common Mistakes to Avoid
I’ve seen founders make a lot of mistakes when it comes to stock options. Here are a few of the most common ones:
- Giving away too much equity too early: It’s tempting to be generous with equity when you’re trying to attract top talent. But you need to be careful. You don’t want to dilute your own ownership too much. Remember, you’re the one who took the biggest risk.
- Not having a clear vesting schedule: A clear vesting schedule is essential for protecting the company. You don’t want to give away a bunch of equity to someone who leaves after a few months.
- Failing to get a 409A valuation: This is a big one. If you don’t get a 409A valuation, you could be on the hook for some serious tax penalties. Just don’t do it.
- Not communicating the value of the options to your employees: Your employees need to understand what they’re getting. They need to know how the options work and what they could be worth in the future. If you don’t communicate this effectively, you’re not going to get the full benefit of your stock option plan.
My Final Thoughts
Stock options are a powerful tool for startups. They can help you attract and retain top talent, and they can align the incentives of your employees with the success of the company. But they’re also a complex legal instrument. You need to get it right.
My advice is to hire a good lawyer who has experience with startups. They can help you set up a stock option plan that is fair to your employees and protects the company. It’s an investment that will pay for itself many times over.
And remember, a stock option plan is not just about the numbers. It’s about building a team of people who are all working towards the same goal. It’s about creating a culture of ownership. When you do that, you’re not just building a company. You’re building a movement.
Frequently Asked Questions
Who is this guide designed for?
This guide is written for founders and operators who want practical, actionable advice rather than theoretical frameworks. Whether you're just starting out or scaling an existing business, the principles here apply across stages.
What if I disagree with some of the advice?
Good. That means you're thinking critically, which is exactly what a good founder should do. Take what resonates, test it, and discard what doesn't work for your specific situation. No advice is universal.
How should I work through this guide?
Don't try to absorb everything in one sitting. Read through once to get the big picture, then go back and work through each section as it becomes relevant to your current challenges. Bookmark it and return to it regularly.