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:
- To compensate them economically: if the company cannot pay in cash the full market salary of an employee (what the company would need to pay in the market to hire the employee), the company is going to need to supplement the cash salary with other financial assets (the stock options in our case) having an economic value approximately equal to the gap between the full market salary and the cash salary.
- To align incentives with shareholders: since participant employees can benefit from the increase in stock value and they can theoretically influence it with their work, they will be motivated to work harder/wiser/better.
- To retain them: since ESOPs have almost always some kind of vesting mechanisms (e.g. one year cliff and three years vesting), employees are motivated to stay in the company at least until the time when they will be able to exercise the options.
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.
- Determine the market compensation for the role (e.g. $100k/year).
- Determine how much you can/want to pay in cash (e.g. $80k/year).
- Determine for how long this gap should be covered. We propose two years. Why? Because a two-year window seems a reasonable period of time between financing rounds (after which sometimes salaries get upgraded) or to see how the business develops — either in a good or bad direction — with an obvious impact in the price of the stock. Following with our example, we would need/want to compensate this employee with assets worth $40k = ($100k — $80k) * 2.
- Determine the value and strike price of the stock options. As we have previously reasoned, we will assume that a fair price for the stock options is the same as the price of the common stock. So, how much is the common stock worth? The most frequent procedure is to apply a discount (e.g. 25%) to the latest preferred stock value, since common stock doesn’t have the same economical and political rights that preferred stock (what VCs usually buy) does. So, for a company whose latest post-money valuation was $5M and has 1 million shares outstanding (no options), its latest price/share = $5. This is the price/share of the preferred stock. The price of the common stock, applying a 25% discount, would be (1–25%) * $5 = $3.75. Since we want those options to be at the money, their strike price will also be $3.75. [Don’t get confused because the strike price and the value of the stock option is the same number. The concepts are totally different!]
- Determine the number of stock options to be granted. This is quite trivial now. We need to give $40k of value in stock options each worth $3,75, so we need to grant 10,667 ~= $40k/$3.75. On a fully diluted basis, this means 1.06% = 10,667 / (1,000,000 + 10,667) of the stock of the company.
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!