How to assign stock options in early-stage startups

Samuel Gil
Mar 17, 2017 · 5 min read

The purpose of this post is to provide a simplified yet still rigorous way to calculate how many stock options a company should grant to each one of the employees participating in a Employee Stock Option Plan (ESOP).

1) What stock options are

A stock option is a financial instrument which gives its holder the right — but no the obligation — to buy an underlying asset (common stock of the company) at a predefined price called the strike price, at a given time (whenever after the vesting period).

When stock options are granted, their strike price is usually the market value of the common stock. In financial jargon we say that those options are at-the-money, their intrinsic value is zero, and all their value is time value. In plain terms this means that initially you would profit nothing by exercising the options, since the price at which you could buy and sell the stock is the same (strike price = market price), but the options are still worth something because the price of the common stock might be higher in the future (the time value).

The two most important factors determining the time value of an option are: (1) the volatility of the price of the underlying asset — how much it can change by time unit — ; and (2) the time to exercise. The higher the volatility and the longer the time to exercise, the worthier the option (options benefit from the positive scenarios and are not harmed by the negative ones because the holder will exercise them — pay the strike price — only if it is worth it).

Given that in startups the time to exercise (let’s say 3–10 years) is very long and the volatility is extreme (the price could easily go to zero or could not-so-easily-but-not-impossibly go to billions), the combination of both is a bomb. Hence, the time value of stock options is yuuuuuge. Yeah, startups are creatures of Extremistan.

2) What stock options are for

There are three main reasons to grant stock options to employees:

In summary, there are three cases in which a company would grant stock options to an employee: (1) because it has to (when the company cannot pay the market salary); (2) because it wants to (when the company wants to motivate and retain the employee); or (3) a combination of both.

3) What stock options are worth

We have previously seen that the value of a stock option is the sum of its intrinsic value and its time value. At the time they are granted, their intrinsic value is zero and all their value is time value.

One could argue that this is actually not very different from what happens with the stock itself of an early-stage startup: it has has practically no intrinsic value (intrinsic value meaning in this case the discounted value of all future free cash flows generated by the company), since the possibility of the company generating free cash flow is still a very remote possibility in the far future.

As a consequence of the previous two statements, I am going to assume that the value of an at-the-money stock option at the time it is granted is approximately equal to the market price of the stock.

4) Making the assignment

After this long but necessary introduction we are now equipped with all the concepts and tools required to fulfill our purpose: to know how many options we should grant to each employee participating in a ESOP.

As a final remark, let’s just clarify that this transaction is equivalent to:

  • The company raises $40k in cash at a $3.75M valuation
  • The company pays the employee $40k in cash
  • The employee buys $40k in stock options with a strike price of $3.75 (10,667 options @ $3.75/option)

As in every complex issue, there are always assumptions to be made. As we always say, we provide ours for illustration purposes. But, if you don’t agree with them, do your own math!

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JME Venture Capital is an early-stage tech VC firm based in Madrid (Spain).

JME Ventures

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