Closing the Information Gap on Employee Option Grants: Part Two
In my previous post (see here) I discussed the ramifications of the Israeli 102 Section approach to taxation of stock option grants and its results in terms of what employees can ask for and employers can reasonably grant. I also presented a standard template for offer letters to communicate more information as to stock option grants so that employees can make an informed decision and not treat option grants as a bonus they can’t ascribe any value to. In this post I will take a look at what is a reasonable “ask” in terms of option grants (check the benchmark grant spreadsheet here), and offer a way to approach the question of how many options should be granted in return for a salary cut.
How can you understand the company offer, and what Is It worth?
The question of how much is all about context: who is already in the company, how much funding did the company get, what’s the role. It is one of the most commonly asked questions on Karma.
First and best way to understand your option grant is asking the company to use the following offer letter template. It’s structured in a way that will help you understand the value of the grant in a variety of dilution and exit situations.
For many, the most important question to ask is what % of the company they are actually getting as that provides some visibility to the upside given certain exit scenario. A company can’t simply write the % holdings being granted as options (assuming option grants are managed well); there are just too many variables at play, like whether other employees or investors will exercise options or warrants they have. However, this doesn’t mean employees shouldn’t ask for the fully diluted number of shares; they should. The fully diluted number of shares would include all issued and promised shares, warrants and options, giving the employee a fairly accurate (even if worst case) estimate of their potential percentage ownership, given the
current company status.
If the company isn’t willing to provide you with the number of fully diluted shares, which is the only way to determine the percentage holding (at the time of the grant), and therefore the value of what you are offered — I suggest you walk away. It is true that the number of fully diluted shares is a somewhat confidential piece of information, but if they trust you to be an employee, they should trust you with this number.
One last point to make is that even when you know what your percentage holdings are, this doesn’t directly translate into your share of a potential exit. That result is governed by the terms of preferred shares in the company and many other factors related to dilution: read what michael had to say about it.
Pro tip: You can use Israel’s Company Registrar to retrieve the last filed company’s cap table and the Articles of Association. This should give you a very good idea of the number of shares and the preference structure of the company.
What should the ask be?
You can get a feel for how many options people are receiving by looking at the compensation part of The Spreadsheet. There are some additional questions you can ask before you make the ask. One technique is to ask how much ESOP options were set aside. This amount is what the board thought all employees should get until the next round. Option grants aren’t made equal and you should assume a power law distribution, with VPs getting exponentially bigger allocations than managers, etc. Having said that, the industry is maturing. It is becoming understood that superstar individual contributors should get higher grants. Even though they may not be good at managing people, they should keep doing what they are good at, especially if they have the ability to make exceptional contributions to the company.
Israeli residents that aren’t limited by the fair market value issue can also try to time grants. Let’s say there is an investment round that is coming up. It will have a dilution impact, but it isn’t known yet. Maybe you can influence the timing of the grant — pre or post round — to affect dilution. However, if you are an American resident, the round will impact the fair market value of the options’ exercise price, bringing an additional factor into the equation (assuming the round was done at a higher price per share).
As an aside, you should know that the 102 Section has a 10% limit. If a company wants to grant more than that, the grantee won’t get the preferred tax treatment. The practical implication of this is that you should think long and hard about the founding team, because adding a founder not in the earliest point at a company’s life can be pretty taxing (pun intended), since you may want to give them shares out of the ESOP 102 plan.
Salary for stock?
One of my pet peeves is giving up salary for equity. Giving up a “guaranteed” salary is totally understood and could be a good investment on your part, but the decision should be risk adjusted.
My favorite “key” to making this decision is X 3. So, if your market salary is 30K NIS, and you will be working for 15K, the delta is 15,000 * (12 months) * 1 (say 1 year period) * 1.34 (the overhead costs of employment in Israel, mainly social benefits). This means you are foregoing 241K NIS. Assuming you convert unpaid salary into equity at the next round’s valuation (a risk in itself), that means you should get 750K NIS worth of options.
Having said that, many people get lower grants and the promise “let’s do this for 3 years” and “you’ll get more later on”. You should be aware that as soon as you sign the agreement and begin to vest, you’ve lost your negotiation leverage, since you stand to lose what you’ve vested, and are still frustrated at having received a below market value salary with no compensation. This situation isn’t good for the company as well, since you may begin to feel trapped and become a poor performer. Instead, I suggest saying “how about you grant me 4/3 of the options you had in mind, over 4 years of vesting. if I keep contributing, you got your options worth. if not, fire me and stop the vesting”. This reduces the conflict and creates some certainty in your future grant.
After reading this post, and reviewing the benchmark spreadsheet (link), I hope employees will have more clarity on the value of their stock options, and a sense of the size of the “ask” they can make. This isn’t just about making information available: companies are better off when their key employees believe they were treated fairly, don’t feel powerless when considering the value of their stock options and believe in the upside potential. In this sense, stock options that are granted in an atmosphere of transparency and trust make for a win:win situation, since the employee values them and recognizes what the employer has granted him/her for what it is worth. This logic extends to the formula I presented above for considering the “exchange rate” of salary for equity, since unfair deals are bound to catch up with the company at some point.
Received an option grant? share it with us on the spreadsheet, so that the Israeli eco-system has more information about real-life grants, and your peers will have an easier time figuring out what they should ask for.