hbs option compensation workshop professor brian j. hall february, 2001 © brian j. hall
TRANSCRIPT
What is an Option?Contract between a company and an employee giving the employee the right to purchase shares of company stock at a certain price by a certain date
-Term or maturity
-Vesting
-Strike or Exercise Price
-ISO/Non-Qualified
-Valuation
-Pre IPO vs. Options in publicly traded companies
Why Options?
• Ownership incentives
• Accounting Treatment
• Retention
• Preserve cash (in start-ups)
Rationale:
Options are not going away any time soon.
Options v. Stock
Value
Stock Value
$.50
$1.50Current Stock Price
Exercise Price “Strike Price”
Option Payoff if you sell today
Nuts and Bolts– Term: How long until you must exercise
-Standard: 5-10 years
• Vesting: When you may exercise (e.g. when you actually “own” the options)
– Forfeit unvested options if you leave.– Standard: 2-4 years (e.g. 33% per year for 3 years)– Sometimes there is a cliff at 1 year, then monthly
thereafter.• Employees may not sell options. They can only
exercise early.
Taxes
• Non-qualified options (most common): Taxed as ordinary income at time of exercise
-Modest tax benefit from deferring taxation
• Incentive stock options (ISOs): Taxed at capital gains rate at time of stock sale. (i.e. not at exercise unless you also sell the stock)
-Huge tax advantage
Valuation (Publicly traded companies)
• Standard option pricing formulas (such as Black-Scholes) are not correct because: -Options are not tradeable -Employees are undiversified and risk- averse
• BS generally overstates the value of an option to an employee or executive because: 1. Employees may leave early, forfeiting unvested
options. 2. Employees may exercise early, shortening the term. 3. Employees are not perfectly diversified.
Option Valuation• But BS is a good place to start, before making
adjustments.• Option value is a function of:
-Stock price
-Exercise price
-Volatility
-Dividend rate
-Risk-free rate• Use the spreadsheet
Multi-Year Plans
• Most option plans are multi-year and this creates confusion.
-New grant each year
-Each year’s option grants vest over time.
Steps to Valuing Options (publicly traded)
Goal: To determine a cash equivalent.
Step 1: Determine BS option values under various times of departure.
• Shorter durations lower BS values directly
• Shorter durations often lead to forfeiture of unvested options
Step 2: Adjust resulting values down because of risk aversion and non-diversification.
•10% discount if risk tolerant
•30% is median
•50% if very risk-averse
Step 3: Adjust for taxes.
Potential confusion: Multi-year options combined with multi-year vesting for each option package.
Example: 5 year options Vest over 4 years (25% per year)
Stay indefinitely versus leave after 3 years
Leave after 3 yearsOption Grant at: 1 2 3 4 5 6 7
V V V V0
1
2
3 year options, lose 1/4
2 year options, lose 1/2
1 year options, lose 3/4
V V V V
V V V V
Options in Start-ups• It is a bit misleading (though not incorrect)
to call options in startups options.
• These options have such low exercise prices that they are often much closer to stock than what we normally think of as options.
• They are also riskier and illiquid.• Very hard to value--like valuing Pre-IPO
equity.
Options in Start-ups: A Quick Journey
Value: $4 million Pre-Money
Number of Shares: 10 million shares
Founder Strike Price: $.00025
First Investment: $1 million
•Calculating the percentage of Shares Sold to Early Investors
InvestmentInvestment + Pre-Money
$ 1 million$1 million + $ 4 million = 20%
-Calculating # Shares Issued to Investors
10 million shares$ 4 million
Series A Shares$ 1 million
=
= 2.5 million Series A shares= $.40 per share ($1 million/2.5 million shares
-Calculating # Shares Issued to Investors
10 million shares$ 4 million
Series A Shares$ 1 million
=
= 2.5 million Series A shares= $.40 per share ($1 million/2.5 million shares)
Ownership before & after Investment
Before Investment After Investment
# Shares%
Ownership# Shares
%Ownership
Founders 10 million 100% 10 million 80%
Investors 0 0 2.5 million 20%
Total 10 million 100% 12.5 million 100%
Creating the Option Pool
• Create a pool of 2.5 million options.
• Exercise price is 10% of Series A (preferred) strike price, which equals $.04.– (Series A strike price is $.40)
New Ownership Percentages
Before Employee Option Pool After Option Pool
# Shares%
Ownership# Shares
%Ownership
Founders 10 million 80% 10 million 66%
Investors 2.5 million 20% 2.5 million 17%
Employees 0 0% 2.5 million 17%
Total 12.5 million 100% 15 million 100%
Second Investment
Value: $10 million Pre-MoneyInvestment: $6 million
Share of 6 million = 37.5%Ownership 10MM + 6MM
•Calculating # Shares Issued to Investors
15 million shares = Series B Shares $10 million $6 million
= 9 million shares at $.67 per share
New Ownership
Before Series B After Series B
# Shares%
Ownership# Shares
%Ownership
Founders 10 million 66% 10 million 41.7%
Investors (A) 2.5 million 17% 2.5 million 10.4%
Employees 2.5 million 17% 2.5 million 17%
Investors (B) 0 0 9 million 37.5%
Total 15 million 100% 24 million 100%
When Valuing Pre-IPO Options
• Think %, not # of options.• Value at last round of financing• Value at next round of financing• How many more rounds? How much more dilution?• Current strike price• ISO/non-qualified• Benchmarks: J-Robert-Scott.com
--See their comp survey.
Some Rough Equity Benchmarks
Executive Title % of Stock Owned
CEO 11.2VP Sales 1.9CTO 6.9VP Business Dev’t 3.6VP Marketing 2.9VP Engineering 2.9VP Operations 2.3VP Finance 1.5
Director Level Hire:Early Rounds of Funding: 0.5 to 1 percentLater Rounds of Funding: 0.1 to 0.5 percent
Negotiating your compensation offer
Be systematic and thorough in analyzing what you want
• Don’t be narrow: you almost certainly have a very broad set of interests.
• Think about tangible and intangibles.
• Think about how you would trade off the tangible and intangibles-you probably will need to make such tradeoffs.
•Be wary of your own biases.
•Many, but not all, people will have:
-A bias toward the measurable. First year salary is measurable.
-A bias toward the short-term
Consider your own BATNA
Don’t ask: “Do I like this offer?”
Rather: “How does this offer compare to realistic opportunities?”
•Don’t manage the search to get early offers that may explode
•Attempt, if possible, to get offers in a short window so they can be compared.
•Exploding offers -Politely ask for more time -Politely request other companies
to give you a faster decision (or “read”)
•Learning to live comfortably with uncertainty-exploring (and perhaps sitting with several options) simultaneously while avoiding fixation on one job or one characteristic of one job-can be painful (“stressful-just want to get it over with”) but very helpful.
•How much do you care about?:
“the building of a career”
“More human capital building: HBS II”
•Negotiating your career
•Be prepared for sticky questions.
Question: “Would you take the job if we offered one to you?”
Answer: “Would you agree to make me an offer if I agreed to accept it?”
--if you don’t want the job.