As an entrepreneur, when you own shares (equity) in your own business, those shares are yours personally and you will own them either until you sell them, or the business fails and they become worthless.
When an employee in your company also owns shares, the same conditions apply, they are owned personally by that person. For both of you, because the shares have no market on which to sell them, the shares are held until there is a liquidity event, like a sale or going public (an IPO) – which is probably a long time off. If that employee leaves the business in the meantime, they may still own the shares, depending on the terms of the Shareholder's Agreement they’ve signed.
That’s not a great situation for you as a Founder because you now have an ex-employee who owns shares in your business, and as a result you have suffered a dilution in your equity in your company. They may be a happy or pissed ex-employee, but either way they have shares that may have considerable value in the future and yet they are no longer contributing towards your business. You could be making use of those shares elsewhere, or holding on to them yourself.
What you want is a mechanism to offer ownership of your business but for the employee to lose that ownership if they leave. That’s what share options do for you. Options can be an incentive for that person whilst they’re employed by you, which are lost when they go.
A share option gives the option holder the right, but not the obligation, to buy shares in your business at a future date. So, when you issue options, you’re not giving your employee a share, but a right to buy a share at a predetermined price. That means the company still owns the shares that the employee has an option on and you’re not diluted until those shares are exercised (purchased).
There are lots of tax and implementation rules around option schemes, and lots of new jargon to learn, but if you want to offer your new employees share incentives but retain control, options are the way to go.
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