A No B.S. Guide to Startup Stock Option Grants
A guide for how many options a startup should grant, and how potential and current employees can evaluate their option value.
One of Skillshare’s core company values is transparency. We share as much information as we can with our team: metrics, financials, long-term vision, challenges. I’m a firm believer that the worst thing you can do is hide information from your team. This doesn’t mean you share everything — our employee reviews don’t get posted on the refrigerator, and there are situations where you can reach information overload. But whether in business or life, when you find yourself hesitant to share the truth you need to take a hard look at what you are doing and why. I’ve found that in most cases being open and transparent is the better option, and the end result is a happier and more effective team.
The goal of this post is to bring more transparency to stock option grants. They are a critical component of startup compensation, yet the process often seems to be shrouded in mystery. In this post, I will walk through how we at Skillshare determine the size of grants for new employees, and show how we help both potential recruits and our current team understand the value and upside that they represent. I’ve included some links to actual calculators that companies can use for new hires, and individuals can use to assess the stock option grants they have today or are being offered by a new company.
At Skillshare, we address this in two ways: 1) a detailed breakdown of the option grant at the offer stage, and 2) a calculator for existing employees to understand the value of the options they have.
For Companies and Managers: Communicating option value to new hires
When we get to the offer stage, we send candidates a slide deck walking them through the offer in plain language. In the deck, the option grant is broken out in detail — both how we got to the number, and our estimated value of that grant.
To determine how many options to grant an employee, we use a slightly modified version of the methodology laid out by Fred Wilson and Union Square Ventures back in a blog post by Fred back in 2010 (and subsequently updated in 2018). The summary is that there are two basic components to determine the number of options to grant: 1) the targeted dollar value of the option grant and 2) the value per option.
To determine the target value of the grant, there is a multiplier applied to the salary for every role/level in the company. Here are the multipliers that we use at Skillshare as of today:
- Exec team/C-level: 2.45
- VP: 1.86
- Director: 0.54
- Specialist/key contributor IC: 0.43
- Sr. Engineer: 0.40
- Engineer: 0.26
- Individual contributor/most staff: 0.23
These multipliers are based on USV’s portfolio company research and, from our experience, they are competitive in NYC tech startups.
You then take the new hire compensation and factor in the multiplier above. For example, the target grant value for an individual contributor making $80,000 a year would be ($80,000 x 0.23) = $18,400.
To determine the value per option, you need to first estimate the true market value per share. We take our current monthly revenue, multiply by 12 to annualize it, and then apply a 5x revenue multiple. You might say that 5x is too low, and it likely is for a competitive finance or M&A process, but at the time this is written it is slightly below our last funding round and we feel it is a comfortable multiple for the purposes of the option grant process. I would rather the multiplier for stock option grants be a little too low than a little too high. For any growth funds out there reading this, I expect more than 5x in our next round so don’t lock in on that number :-)
You then take your estimated market value per share and subtract out the current strike price. Some companies skip this subtraction and just use the market value, but in later-stage companies, the strike does start to become meaningful so at Skillshare we take it out. In the generic example below, we get to a $13 value per option. This is the $15 estimated market value per share less the $2 strike price.
The final step: you then divide the target grant value ($18,400) by the notional value per option ($13) to get to an initial new hire grant of 1,400 options (rounded to nearest 50).
Below is what we show new hires in their offer deck (again, not Skillshare’s real numbers — this was made generic for public consumption):
We have made this spreadsheet available at this link, “Output for Soft Offer Deck”. I also flipped this around to the candidate’s perspective and created another worksheet — “Stock Option Grant Evaluator for Candidates” — so that the same rationale can be used by candidates evaluating an offer.
We send this output as a page in a soft offer Google Slides deck to candidates first. Once we have a verbal agreement, we send the formal offer letter for signature. In addition to the offer details, this soft offer deck talks about our values, our mission and vision, and why what we do matters. Based on the feedback from new hires, the slides do a much better job of communicating the opportunity and what it means to work for Skillshare than a typical offer letter.
For Companies and Managers: How we handle refresh grants
Once you are an employee, there are 3 ways to get additional stock options.
1) Biannual refresh. Every 2 years, we grant you 25% of what a new hire would receive in your role at that time. So if new hires at your level/function are getting 4,000 options as of your 2 year anniversary, you would get a refresh grant of 1,000 options.
2) Merit grants. If you’re doing a great job, we give you additional grants. I think of your cash comp as reflective of the value you are bringing day-to-day and your equity grants as a reflection of how you will impact the value of the business over the long-term. If you are doing amazing work that will drive long-term value for the business, we may give a merit grant as part of our standard review cycle.
3) Promotions. When you get promoted, we run your comp and level through the options calculator for that role. We then grant you stock options to get you to the same level as a new hire in that same position. In the event that you already have more options than that level (due to being a very early employee, or getting merit grants in the past) we treat it like a biannual refresh and give you 25% of what a new hire would get.
For employees: Calculating the value of your stock options
We’ve been using our soft offer deck and option grant data for a while now, but after a recent company-wide meeting I realized we were not doing a good job of explaining the option value to our existing employees. Skillshare’s revenue has grown more than 6x over the last three years, so our potential equity value has grown to a meaningful level for many employees. I created an employee stock options calculator to help them understand the value of their options today and the potential value if we execute well.
It’s broken into three parts: 1) the inputs of your current stock option grants, 2) the value of your stock options today given a specific valuation multiple, and 3) the potential valuation down the road if we execute well and things break our way.
In part 1, you enter the details of your current stock option grants. It calculates how much you have vested to date, and how much it will cost you to exercise those options.
In part 2, you enter the company’s current information to get an estimate of what the company is worth today, which then tells you how much your options are potentially worth and the value that gets vested every month.
And finally, we get to the fun part: what we could be worth if we execute well. This is the area where many companies and HR teams get uncomfortable, and that’s reasonable. Throughout these calculators, we have caveats galore that the reality is that the stock options could be worth $0. In the end, this is all just math and the output is only as good as the assumptions in the inputs. I love working at Skillshare because we have a mission I believe in and serve an amazing creative community, AND we have a unique opportunity to build a very valuable business. I understand the concern about employees getting ahead of themselves on the value of their option grants, but I also want to be sure everyone understands the personal financial impact of executing day-in, day-out, and building a great business. It is the responsibility of the company’s leadership to educate the team on the potential as well as the realities.
Again, I’ve posted a generic version of this stock options calculator below that you can copy and use for yourself or your own employees.
A final word on transparency
It’s easy to be transparent when all the numbers are good and the truths are happy ones. It’s a lot harder when the numbers are bad and the truth is uncomfortable. Giving recruits and employees access this valuation and option data will generate questions, some of which may be tough to answer. Either way, the truth is going to come out at some point, so you might as well be transparent and ask for help in addressing the company’s challenges. The right people feel energized and empowered by being part of the solution. Those that run away weren’t going to help much anyway.
I hope these calculators are helpful in creating a culture of transparency at your company. Any comments, questions, or suggestions are appreciated!
UPDATE NOV 2020: Adjusting how you calculate the value of an option as your company grows
In the model above, there are two key components: 1) the target $ value you are trying to grant the employee, and 2) the value of an option. Dividing #1 by #2 gives you the number of options to be granted. The target value is based on market comps that USV has assembled based on their access to real data among their portfolio companies and other sources. In the model above, you calculate the value of an option by taking the difference between the strike price (as determined by the Fair Market Value defined in the 409A valuation) and the estimated true market value.
This works well for companies earlier in their development — seed stage, series A/B/C. But as companies grow and start heading toward IPO, the difference between the strike price and the estimated true market price starts to narrow. In public companies, options are granted at the actual stock price so there is zero difference between the two. So at some point, you have to start valuing your options using public company methods which typically involves the Black-Scholes option pricing model.
I’m not going to go deep into Black-Scholes here, as it’s a much longer discussion, I’m not an expert, and the math that makes my head hurt a bit. But the summary is that Black-Scholes is a well-respected way to price options that accounts for the company’s value, the strike price, the volatility of the stock price, and other inputs.
To run this version of the calculator, you’ll need 3 new inputs:
- Time to maturity: the longer the duration of an option, the more valuable it will be. Most incentive stock options in the US have a 10-year maturity, but you’ll need to account for the vesting schedule. Assuming a typical 1-year cliff and 4 year total vesting period, you can use 6.25 as the average time to maturity.
- Annual risk-free rate: I used the 7-year treasury rate.
- Annualized volatility: You should be able to find this number in your most recent 409a report. If you don’t have, it 70% feels like a reasonable plug for most growth companies.
In both the template for companies and candidates, I’ve added a second tab that swaps out the “notional value of an option” for “value of an option based on Black-Scholes”. I take these three new inputs along with the current strike price and the estimated market value per share, and the Black-Scholes formula spits out a new value per option. The rest of the calculator is the same — you take the $ value targeted and divide by the value per option to get the number of options granted.
Again, for most early-stage companies, the simpler version is still the best model. But this update gives you a structure you can leverage through IPO and beyond.
Here are the links to the calculators:
- Option value template for new hires/offer deck
- Option grant value calculator for candidates
- Option value calculator for current employees
Special thanks to Fred Wilson, Zach Goldstein and Bethany Crystal from USV for all of their work on the option grant structure and market comps. Here are the posts from Fred: