What are stock options? Why should a startup adopt an option plan?

Stock options represent the right to purchase common stock at a set price. That price, called the exercise price or strike price, typically corresponds to the value of the stock granted at the time of grant. Unlike common stock, options don’t require an up-front investment from the grantee. They traditionally accrue to the employee over a period of time (usually 48 months) through a vesting schedule, so the employee’s contributions match their equity reward. Once options have vested, the grantee can exercise those purchase rights to buy stock at the exercise price—which will be much lower than the price of shares at the time of exercise if the startup has been successful.

To be able to grant options, a startup must adopt an Equity Incentive Plan, more commonly known as an option plan or EIP. Gust Launch Raise makes it easy to adopt a plan that conforms to best practices and investor expectations, and option grants issued through Gust Launch integrate directly into your existing on-platform cap table and ownership records.

Typically, startups create their plans before their first round of professional investment, or after they’ve raised around $50,000 on convertible instruments. Before a startup can adopt a plan, the company must fulfill some legal and fiduciary obligations (as well as some housekeeping within Gust Launch).

Founders earmark a set number of shares of their common stock and allocate these shares to the option pool when they adopt their Equity Incentive Plan, which makes them unavailable to grant as common stock and also causes the shares to count toward the company’s fully diluted sharecount. Since investors (and other stakeholders) typically look at ownership in its fully diluted form, this distinction is important.

Startups typically grant stock options to people other than founders or investors—most notably employees. Because granting stock options is a standard startup practice, employees who are willing to work for an early-stage company generally expect them in return for taking a job that comes with more risk than they would have to tolerate at a well-established company. Without the ability to grant options, a startup would be at a disadvantage to its competitors when it sought to recruit and hire employees.

Since employees (and especially very early employees) will expect an equity stake in the company, investors also expect any startup in which they invest to have a legally sound option plan with a sufficient number of shares allocated to incentivize all hires necessary to reach the next fundraising round.