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Employment, Entrepreneurship, Funding, Options, Startups, Technology, Venture Capital

The Disposition of Equity: Incentive Stock Options Part 1

iStock_000000647760XSmallNo advice seemed more reasonable, more universal and at the same time became so profoundly nettlesome as the creation of an employee option plan and its correct apportionment in the company. While equity options in the startup can be a powerful motivator and an invaluable tool for the distribution of value it can also sow confusion and dissention, particularly among less experienced employees and those naïve in the groundings of ventures, risk and capital.

In this short article I share my experience for the benefit of other founders, employers and employees providing my unique perspective on this issue. Why create an options plan? How much equity should go into it? How much should each individual employee expect? How should equity options be considered as a component of compensation? How are they valued by employees? These are important considerations that can have significant impact on success or failure.

Options 101

First a brief word about what options are and the mechanics of their operation in a company. An option is the right to buy or sell shares of stock in a company at a given price, referred to as the “strike price”, within a given time frame, “the term”. There are all sorts of nuances to this such as call options, which give the right to buy, put options which give the right to sell, European style options which can only be exercised at term, American options which can be exercised at any time up to term and barrier options which trigger a rebate payment if the value of the underlying equity crosses a barrier etc. In the context of employee options we are typically talking about incentive stock options (ISOs) which are call options that give the bearer the right to buy stock in the company at the strike price at any time within the specified term.  ISOs may only be distributed to employees and are subject to other restrictions. ISOs typically have a vesting schedule over three or four years. For example if you are issued options for 100 shares of your company, 25% of those options might vest after one year with the rest vesting quarterly over the subsequent 3 years.  The 25% event is sometimes called “the cliff” and its rationale is to both encourage employees to stay on and to wait out the first year which is the time a new employee is most likely to leave either voluntarily or involuntarily.

Options plans sometimes include an employee-friendly provision, as in the SRT plan, that automatically vests outstanding options if there is a liquidity event such as an acquisition.  Astute employees should recognize that the number of optioned shares you are offered is completely immaterial. 1,000 shares in a company with a capitalization of 10,000 shares are potentially worth a lot more than 1,000 shares in a company with a capitalization of 1,000,000 shares. The meaningful metrics are the percentage of fully diluted shares that you have title to through the grant and the estimated value of the company. Fully  diluted shares includes all distributed shares added to outstanding options, warrants and any other outstanding claim to company shares.

When an employee wishes to exercise a vested option within the term he or she can purchase shares of the stock at the strike price. Why do this? If a company is acquired or the stock is actively trading on an exchange and its market price is greater than the strike price, the employee can realize the difference as profit by exercising the option to buy the stock and simultaneously selling it on the exchange. CAUTION: If an employee exercises his or her options, tax must be paid on the difference between the market price and the strike price. Many people have ensnared themselves in trouble by exercising their options (thereby incurring the tax debt to the IRS) and holding the shares while the value of the stock collapses. In that case the shares are not worth much but tax is still owed on the capital gain. A prudent resort is to always sell enough shares to cover your tax liability.

Why an options plan?

An options plan is a vehicle to share value with employees to encourage creative work, diligence and loyalty. It’s also a way to provide compensation to employees for some combination of sub-market salary, long hours and/or additional risk they may be taking by joining a startup as opposed to a large company. The latter concept is a straightforward extension of the classic financial principle that risk and reward are correlated. My ideas on equity distribution prior to forming a company always included ample allowances for employee ownership in the form of stock options. It was obvious to me from the perspective of objective fairness and subjective motivation that value creation had to be shared among the team that produces it in order to be effective, particularly in a technology company where an individual’s efforts can have a big impact.  In my view options are meant to motivate effort and reward loyalty and therefore they are only effective with current employees. If its undesirable for equity to walk away from the company the plan should include a provision to buy back vested options and shares from departing employees. Equity options in the hands of ex-employees is value that you can’t give to current employees to motivate their efforts.

Options as a legal construct

Options are a legal and financial construct, like the idea of private property or the idea of borrowing money with interest. They act in alignment with human self-interest to channel and unlock value creation. I often hear pointed criticism directed towards lawyers and “Wall Street” financiers particularly from technology savvy individuals. Some of these barbs are warranted but we should not miss the much larger point that the legal/financial structure that has evolved in the U.S. and a few other market driven economies is an essential and precipitating element to our economic vitality and success. The system that our financiers, lawyers and accountants have produced, with all its attendant warts and imperfections is still a crown jewel that gives this country competitive advantage. The process of starting a company, the ability to share value, to finance and to realize the value created is one of several reasons the U.S. has a thriving and vital startup culture not shared by many other nations.

Valuing the company

Several important decisions need to be made in the creation of an ISO plan. The first is the valuation of the company to set the strike price.  With all the talk about startups and business plans, venture and angel money that goes on in business school they never seemed to get around to the thorny subject of valuing an illiquid venture that most likely has no revenue or track record. It’s a little surprising given the emphasis on vehicles like options as de-rigueur accessories to startups. Perhaps with funded startups this question is more easily addressed because company value will be grounded by the last funding round in some way. If a company is not venture funded, not making much money at first and there is no history to consult…how much is it worth? It’s an essential question because a strike price is required for the option plan. It turns out that there are services that will value your company for a fee. Unfortunately this fee can be out of range of many startups, particularly those bootstrapping, and the prospect of paying tens of thousands of dollars to value a company that may not be worth much more than that on paper is out of proportion. Typical valuation approaches such as discounted cash flow or comparison with market peers that have a liquid market are not applicable because the early stage company will most often not be profitable…in many cases it might not even have a revenue stream. Fortunately the IRS has recognized this as a problem and has provided some guidance. IRS section 409A focusses on the valuation of common stock of privately held companies for the purposes of setting option strike prices. Specifically it applies to non-qualified options which are options that don’t qualify as ISOs, however the valuation methodology outlined is also applicable to ISOs. The IRS recognizes the difficulty in valuing small illiquid ventures and section 409A discusses two approaches, the “start-up” valuation method and the “formula-based” valuation method. Details are provided in the following useful links.

http://www.groco.com/services/valuationissuesqa.aspx

http://www.nixonpeabody.com/117615

http://www.mbbp.com/resources/business/stock_option_pricing.html

Incentive stock option plans represent a broad topic with important implications for small companies so I divided my discussion of them into two parts. In Part 2, to come in a few weeks, I will discuss ideas to guide thinking on the size of the option pool, its fair apportionment in the company and I share some final thoughts related to how employees and employers might value ISOs.

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About vnatoli

Entrepreneur;Physicist

Discussion

2 thoughts on “The Disposition of Equity: Incentive Stock Options Part 1

  1. Option plans and the incentive can be complicated and the odds of an employee understanding the value of the option properly and being properly incented/motivated is not guaranteed. Also, depending on the structure of the options, the events that cause the options to gain or lose value are often largely out of the employees control or even significant influence (e.g., the decision to take a funding round or the ability and decision to go IPO). Alphatech (before BAE bought them) had a system that worked fairly well. They had ISOs, but they also had a semi-liquid internal market for shares with a realistic company valuation process (since they took no venture funding nor contemplated an IPO — they had one significant event, i.e., the company was sold to BAE). Whether it is a correct way to view options or not — I came to view them simply as lottery tickets. I think they make sense for the first N employees (N<=10?) or a key later hire, but I am not so sure about anything past that.

    Posted by Howard Reubenstein | August 5, 2013, 9:21 pm
  2. Alphatech sounds like it was organized like SAIC. I think for a big company like that you are right. Its a slow growth organization that generates cash. This is in contrast to a small technology startup which has an intense period of investment and development leading up to a product that is worth significant value. I had to split this post in two parts because it became too long. In part 2, which I’ll post in a few weeks, I share some of my thoughts about option pool size, what employees might and should expect and some of the ways that I think people value options. I’ve heard people say they are lottery tickets and I suppose for some companies that can be true. If that’s the case though then you’d be better off distributing cash to employees. To be effective I think employees should be able to draw a pretty clear line from their work and effort to the success of the company.

    Posted by vnatoli | August 8, 2013, 6:33 pm

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