This article was first published on LinkedIn

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For startups, equity and stock options play a pivotal role in attracting and retaining top talent. In the African context, at the very early stage of the company, equity and stock options can serve as the leverage to get committed employees to stay and build in exchange for a future reward. For founders who are trying to navigate the complexities of building a successful and sustainable company, the ability to understand the nuances of early exercise stock options is extremely vital. In this guide, we break down equity, explore the intricacies of stock options, and shed light on the factors influencing African startups to permit early exercise.

Understanding Equity & Stock Options

Simplified, equity is ownership or interest in an asset or company. In the startup world, it refers to the ownership stake that shareholders hold in a company and it is one of the key components of a company's capital structure. It is usually measured in terms of shares and the owners of equity are often referred to as shareholders. A shareholder can claim ownership of the company’s assets and earnings in proportion to the percentage of equity ownership.

Equity serves as a powerful tool to align employee interests with the long-term success of the company. Employees can be given ownership in the company through various instruments which include, Stock Options, Restricted Stock Units (RSUs), Employee Stock Purchase Plans (ESPPs), Stock Appreciation Rights (SARs), Employee Ownership Trusts (EOTs), Phantom Stock Plans, Direct Share Ownership and Convertible Securities. Of all these instruments, the most popular for startups are stock options. With stock options, employees have the right to purchase shares at the company at a predetermined price which then helps build a sense of ownership and an interest in long-term commitment at the company.

For African startups, establishing an employee pool for equity distribution is a strategic move. In the early stages when attracting top talent is crucial, a well-structured employee pool can be a tool to build a motivated and committed team. Employees can benefit from potential stock appreciation and they will usually need to exercise the options by purchasing the shares at the exercise price to become shareholders. An employee stock option pool sets aside a portion of a company's equity to grant stock options to employees to align their incentives with the company’s growth. Though it’s a great reward, there are certain mistakes to avoid when issuing stock options.

Exercising the Stock Options

Because stock options are usually shared to incentivize loyalty and commitment, they usually come with a vesting period. That is a specified duration that an employee must stay at a company before being entitled to the full benefits of the stock options. The vesting period is often expressed in terms of years or months and usually includes a “cliff period” which is a specified period at the beginning of a vesting schedule where no equity vests.

Employees are usually required to pass a cliff period before they become eligible for any vesting of their equity. Then after the cliff period, a significant portion of the equity may vest in a lump sum, and then subsequent portions vest gradually over time. For example, a company might offer employees a four-year vesting period with a one-year cliff and monthly vesting. When the vesting conditions have been met and the employee chooses to take advantage of the opportunity, then they can exercise their stock options.

Exercising refers to notifying the company of the intent to buy a specific number of shares at a predetermined price known as the exercise price. To acquire the shares, the employee then pays an exercise price per share which was set at the time the option was granted and will not change regardless of the current market value of the company's stock. Once the company has received the payment from the employee, the company then issues the number of shares to the employee and thus makes them common shareholders of the company.

Employers can also opt to provide early exercising, which involves employees exercising their stock options before they have fully vested. However, some factors can influence startups to permit early exercise.

1. Talent Attraction & Retention: In a competitive environment, the early exercise of stock options can be an innovative option to attract and retain skilled professionals in an organization. It helps boost trust in the organization and also motivates employees to commit their talent.
2. Laws & Regulations: The regulatory environment of the African region can also influence the decision to grant early exercise options to employees. Startups must ensure that they are compliant within the country of operation.
3. Shared Vision: When employees are granted an equity stake in a company early on, it creates a sense of a shared vision and encourages a focus on growth among the workforce.

Benefits of Early Exercising for Employees

• Immediate sense of ownership: A huge benefit of early exercising is immediate ownership in the company.
• Risk Mitigation: Your employees lock in the current valuation of the company thus mitigating the risk of future increases in the stock price.
• Tax Advantages: In some countries, early exercise can offer tax advantages.
• Voting Rights: Employees get access to participate in decision-making opportunities.

There are also certain risks involved in early exercising. Some of them include;

• Limited Liquidity: Since most private companies have stock that isn’t liquid, employees might face challenges with selling early until the company has gained some certain liquidity. This can typically occur after an IPO or an acquisition.
• Valuation: There is a tendency for a company’s valuation to not meet expectations hence resulting in a financial loss for employees
• Financial commitment: Early exercising involves early financial commitment to purchase the stock options. This can be quite challenging for talents at the early stage of their careers.
• Loss of Employment: An employee who has to leave the company tends to lose the unvested portion of their stock options.
• Tax Implications: It’s important to understand the tax implications of early exercising within the company’s region of operation.

A guide for early-stage founders.

Now that we understand the concept of stock options and early exercise, here’s a guide to help you make the right decisions for your company.

1. Be Compliant: Get familiar with the local regulatory landscape in your country of operation. Have a deep understanding of labour laws, securities regulations and other legal compliance requirements.
2. Align equity with your company’s interests: Use equity to align the interest of your team with the sustainability of the company. Ensure that you foster a culture where everyone is equally aligned to achieve a common goal. Tailor your equity policies to align with your broader goal.
3. Clearly communicate: Make the communication of the benefits of early exercising simple and clear to your employees. Ensure that they also understand the risks involved.
4. Get Professional Help: Reach out to professionals, such as the Raise team with expertise in company structure and organisation to provide quality guidance for your equity programs and help you remain compliant.

Early-stage founders can use the early exercising of stock options as a strategic tool to increase employee commitment. With a combined culture of ownership, transparency and trust, employers will be able to attract and retain talents as well as create a thriving ecosystem where every team member contributes to the journey of sustainable growth.

Need assistance? Chat with the Raise team

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