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Here is a reasonably comprehensive set of definitions from Salary.com related to employee stock options.
Employee Stock Options: Terms and Definitions
One should also be familiar with Rule 144 from Securities Exchange Commission which relates to how stock options can be sold into a public market. I will cover Rule 144 in a separate blog post.
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The most frequently asked question is "How many stock options should I receive?" or in effect, "What is the right amount of stock options for my position as a VP/Director/Manager of ___________?"
The quick answer is that most organizations, regardless of size, have established stock option grant "bands" or ranges of amounts of stock options that are to be granted to new hires based upon salary and title. So, if you're a director making a $100k salary, there's an expected range amount of options for that position/salary combination. Let's say, for example, that the option band or range is anticipated to be between 3,000 and 5,000 options.
So your questions should logically be --
1. How many options am I being offered?
2. What is the band or expected range for this position?
3. And, if necessary, why am I receiving less than the full amount offered for this position?
You can't argue the price of the options as this is set by accounting and tax statue in the United States to be the current fair market value of the stock option on the day it is granted by a company's board of directors.
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As a matter of protocol, Board of Directors typically are presented with a number of option grants to approve within any particular Board meeting. The grants are usually made up of recent hires who are receiving an initial stock option grant. The Board will usually ask if these grants are within the pre-established bands for the salary/position combination. If the answer is yes and there are adequate shares available for the option grants in the company pool of stock options, the Board will readily approve the proposed stock options grants. So, if you push for the top end of the available band but don't exceed it -- it won't require much management attention to get approved by the Board of Directors.
Please note: I have written on a few of occasions about employee stock options in a start up. (See links below if you have a further interest.)
Vesting Employee Stock Options
Understanding Start Up Options
Employee Stock Option Pool Size and Option Amounts
From time to time, I will write about some of the terms and conditions of employee stock option plans that can have a major impact for the founder(s) at the end of the day. Given reader response to my previous blogs on the option subject, I want to call attention to vesting.
The vesting of stock options over some designated period can have dramatic economic impact for founders.
Vesting
Stock option plans will have a vesting period where the right to purchase the granted stock options increases annually and sometimes monthly. So the stock optionee gets 1,000 options that vest over a four year period in quarterly amounts, meaning that employee vests and has the right to purchase the options following the completion of each year of employ. In our example, Employee has the right to buy to 25o options after year one of employment. The Employee will usually have that right for some period of time so long as they stay in the employ of the company. It can be up to 10 years to purchase the vested options.
The question arises -- if the founder is the source of the original stock options to supply the stock option pool -- where do ungranted or un-vested options go when the company sells? Consider an example where the ungranted and granted but un-vested options total 10% of the company at the time of company sale. These options were all originally the founders' shares. Where do they typically go at exit? The custom is for them to divided on a pro rata basis amongst existing shareholders. So if investors hold 70% of the company and management/founders hold 30%, then the shares will go 70% to the investors and 30% tothe founders/management.
In this oversimplified example, the issues are obvious. In real life, the sale frequently occurs after the original option pool has long been exhausted and the bulk of the options are vested to the grantees. That said, better to be in command of the issue than not.
So you been offered 3,000 or 200 or 15,000 or 100,000 stock options in a start up? What does that mean? How do you determine their worth now? What should you expect them to be worth later?
First things first, let's look at the options themselves. The stock options cannot be understood without knowing the "entire fraction" -- that is to say that the offered options are the numerator of a fraction. To know the whole fraction, meaning the numerator as well as the denominator is the starting point for evaluating a stock option. Having 3,000 stock option shares in a company with 30,000 total shares is 10%. Having 200 stock options in a company with 30 million shares is nice but it may not be all that profitable. Here again, the value of the shares is the ultimate determinant of value but one can't discern too much of anything based upon the raw number of options (the numerator alone).
The options should be worth nothing when they're granted. Since options usually vest over time and the U.S. tax laws dictate that unless the options are provided to you at today's cost then it it is a current taxable event, one wants them to be worthless on the day they are granted. If the options are granted at less than the fair market value, then the granting of them creates a taxable event. So, the correct answer is that the options are valueless when you receive them.
So what will they be worth? Knowledge of the numerator and denominator is necessary to begin this estimate. What will the company be worth in 2, 3, or 4 years? This answer is typically derived at looking at the valuation of public companies in the same or comparable industries. The key ratio is usually the sales multiple. That is what is the value of the company expressed as a multiple of its sales. A company with $50M in sales that has a market capitalization of $200M has a sales multiple of 4. So, what are the common sales multiples in your industry? With that number in hand, the equation becomes estimated sales of your company times the industry sales multiple times your ownership fraction. Or, $50M times 4 equals $200M and your .25% options equate $500,000. So a little can be a lot with stock options. Or a lot of options can be worth a little.
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One area of interest to investors and entrepreneurs alike is the size of the employee stock option pool post financing and the "typical" grant sizes for key employees.
As a rule of thumb, one should assume that a post A Round company will need to support a CEO, three VP's and 5 to 7 directors with incentive stock options from the stock option pool. And while circumstances vary widely to affect the proper amount of options to a position, the general consenus is the following for various positions:
CEO - Option Grant of 4 to 8%
VP's - Options of 2 to 3%
CFO - Options of 1to 3%
Directors - Options of 1/2% or less
All of which dictates a need for an option pool amount around 20% of the post A round share amount. Founder CEO's with shares or other particular facts may influence this and all generalizations are dangerous.
The right amount for any situation is and should be the focus of a fair amount of discussion.
Leonard Mlodinow: The Drunkard's Walk: How Randomness Rules Our Lives
Robert I. Sutton: The No Asshole Rule: Building a Civilized Workplace and Surviving One That Isn't
Ted Leonsis: The Business of Happiness: 6 Secrets to Extraordinary Success in Life and Work
