Startup Employee Stock Options

Posted by on June 8, 2011 at 7:40 am.

John NesheimI’ve wanted to share a post about entrepreneur stock option planning for some time; one of the standard discussions I have with every founder I back shortly after we close funding together. Surprisingly there aren’t many thorough posts on the topic, but I did find a quality series posted by John Nesheim back in 2007. John is a Cornell lecturer and has authored a couple books on company building, including High Tech Start Up and The Power of Unfair Advantage.  His post not only covers stock option planning, but also puts it in context of overall equity & hiring plans from startup to exit. I will admit his process assumes more time, people and exit predictability than most startups can expect, but it’s better to have a base plan that can be tweaked when the world changes than to not plan at all.

Stock options are a powerful forward-looking piece of employee compensation to create an equity-minded organization.  Proper option planning can be key to hiring, growing, securing investment and minimizing long-term entrepreneur dilution. I hope you enjoy John’s guest post below and let me know if/where you think his process could be improved for real world application.  If nothing else, going through the thought process is so much better than dishing out options based upon “what sounds right”, “whatever it takes” or what current employees expect for their past effort.

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STOCK OPTION PLANNING: Step 1 laying the foundation

You asked for it, so here it comes: A series of blogs on how to prepare a good plan for granting stock options to employees. If you get confused, try purchasing the QuickUp Model and follow the instructions.

  • Step 1: Lay the foundation
  • Step 2: Classify employees
  • Step 3: Price the stock option per employee
  • Step 4: Test the market

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Step 1: Lay the Foundation

(A) Forecast all the rounds of venture capital you will need up to the day you go IPO.

You will need several rounds of financing, typically three in three years. It can be several more. Life science requires at least twice that number of rounds. The first two financing events are the Seed Round and Round A. The third is Round B. The naming is confusing, I agree. Just be clear and understand what each round is intended to accomplish. Each round needs the following information:

  • Pre-company valuation in millions of dollars
  • Cash to be raised this round
  • Pre-company number of shares. This includes stock options.

Ignore for now the difference between common and preferred shares.  With this information you can calculate the number of shares to sell the investors.  Now you have the total number of shares of the company: founders, employees and investors.

(B) Forecast all the employees you need up to the day you go IPO. Use as much detail as you can. Work from CEO to VP to Director to Manager to Employee.

(C) Do your first estimate of how many shares you will need for your stock option grants. This becomes your stock option pool. For now, ignore the cost of the stock per option per share.

(D) Add the stock option pool shares to your total shares of the company. This includes founders, stock options and investors and together equals the total shares.

BOTTOM LINE: This is the first step to building a quality stock option plan. It is worth doing well. Attracting outstanding people in a very competitive market for top talent calls for the best stock option plan you can create. It will be central to your unfair advantage. Tomorrow I’ll show you what to do for Step 2. Don’t give up yet, you CAN do this!

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STOCK OPTION PLANNING: Step 2, classify the employees

Today we take Step 2: Classifying the employees. I hope you have at least guessed at the numbers for Step 1 (see yesterday’s blog). Guessing is what serial entrepreneurs do. Then they modify their initial estimates. That is how they build their plans. It is like shaping a lump of clay into a beautiful statute.

Step 2: Classify Your Employees

Pick layers of employees. For instance: CEO, Vice President, Director and Employee. Each layer is often named a classification.
Add the layers to your forecast model. Use Excel or equivalent spreadsheet.

Forecast the number of employees for each layer. Do it for each of the first 24 months and each year thereafter, up to the day you plan to go IPO.
Now you have your company’s employee forecast. Congratulations, you are already ahead of 95 percent of the rest of the startup CEOs who are competing against you for venture capital. You will look very professional when compared to them. The investors might even think you know what you are doing!

Note that with this classification it is easy to begin to add wages to your financial forecast. That will account for 60 to 80 percent of your costs. More detail gives you a higher quality forecast. And you look even sharper to investors. You will find this easy to do with a financial model such as QuickUp.

BOTTOM LINE: These few words and a bit of extra work with get you farther than most of your competitors in planning a good stock option plan. With the wages and options pre-calculated, you will have the best insight for negotiating the cash and shares you need to build your unfair advantage. Tomorrow, Step 3, Price the stock option per employee.

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STOCK OPTION PLANNING: Step 3, price the stock option per employee

Today, Step 3 will get you close to completion of your stock option plan. To understand this you need to grasp how to structure the capital of a world-class venture backed startup.

CAPITAL STRUCTURE

Common stock goes to employees and preferred stock to investors. The price per share of the common stock starts on day one equal to one tenth the price of the preferred stock. That gap will close year by year as the day for IPO approaches. For more details on what is going on here, see Chapter 9 of High Tech Start Up.

Form a simple legal corporation not a partnership. LLCs and S corporations and others get you into blind alleys and will eventually trigger intellectual property, tax and stock option messes that are terribly hard to repair.

Get an experienced lawyer to set up your capital structure. Mistakes are costly.

COST PER SHARE

Start pricing each round of preferred stock. As noted in Step 1, you need a plan for each round of stock sold to investors, year by year. Calculate the price per share of preferred. This is what is used to determine the value of your company.

Price the common shares. Gradually close the gap between preferred shares up to the day of IPO. This will be the strike price, the cost per share to the employee when they exercise the stock option (buy shares).

BOTTOM LINE: That was not too difficult for you, I am sure. Examine what you have created in your spreadsheet or QuickUp model. A good model will save you days of frustrating work. Your work so far should make good sense to you (and your lawyer). By now your efforts will have create everything you need for your stock option pool, except the total number of shares. That we will work on in tomorrow’s blog (meanwhile, give it a go, a guess) and get ready for Step 4, Test the market.

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STOCK OPTION PLANNING: Step 4, test the market

The final step is to determine how rich each employee should expect to be on the day of the IPO. With an IPO value per share (Steps 1 and 3) you can then calculate the number of shares to grant to each employee. To do that you need to know your local labor market, especially how much wealth it takes to attract the people you plan to recruit. Here are things you need to do:

FIRST TASK

Dig to discover the wealth people expect to earn on IPO day. That requires knowing both wages and stock wealth requirements for each class of employee. You learn that by spending time talking to recruiters, lawyers, accountants, human resource managers, and doing your job as a manager in a real corporation. That on-the-job experience will reveal what IPO wealth targets are expected by the talent your startup needs. “A vice president of engineering will expect something like $10 million in today’s market for startup talent for a company in this early phase of its growth” is what you will end up concluding.

Add the wealth target to each classification of employee. Add the dollars of wealth at IPO per employee to each class of employee, the classes you set in Step 2. Yes, there will be a range of wealth expected. For now, use a single number. That makes your task easier. You can add highs and lows around the number later.

Calculate the number of shares for each employee and add them up. With the dollars of wealth per employee times the number of employees in each classification, take the price per share at IPO time (see Steps 1 and 3), and divide it into the dollars of wealth per person to get the number of shares for the stock options. Add all the shares up and you have the total you need for your stock option pool.
When you have completed this task, you can calculate a table per year of the percent of the company each employee will get each year. That is the shortcut, the end point, used to negotiate during recruiting. “The vice president of biz dev will get 1.2% of the company” is what is meant by this.

SECOND TASK

Use risk reduction to modify the number of shares granted each year for each classification. A director of product marketing joining in year three will get fewer shares than if he joins in year one. A growing startup will reduce risk each month as it makes progress to IPO date. Less risk means less stock per option grant. Reduce the number of shares following the price per share curve you got when you sold stock to investors. This will alter the total number of shares in your option pool, most likely greatly reducing the number required. Alter your plan accordingly.

Set the strike price for each option each year. The price per share will be projected to grow each year so the strike price will also grow each year. It will rise faster for common stock than preferred stock and gradually close the gap, rising to the same price as preferred stock by IPO day. In the early days of your startup it is common to increase the strike price per month during the first twenty four months.

BOTTOM LINE: Now you have the total number of shares for your option pool. They are allocated to classifications of employees. You have the total number of planned people to hire. Each year the number of shares granted will decline per job because the risk is lower. Each year the total number of shares will probably increase because you hire so many people. The cost of each option will rise each year as your company becomes more valuable. The focus of everyone’s attention is on the value of your company on the day of IPO. People think in terms of percentages in the beginning and convert to number of share thinking by IPO day. “My 123,000 shares times $20 per share make me very rich!” The absolute wealth per person on that day is what individuals dream about. When you get those numbers right you will be able to attract top talent in competition with other startups. Your plan will be a key to construction of your unfair competitive advantage.

If all this is overwhelming to you, examine Chapter 9 of High Tech Start Up and Chapter 22 of The Power of Unfair Advantage, try using QuickUp and find people who can explain it to you until you can do it alone. It is one of the most important skills you can learn as a startup CEO.

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4 Comments

  • Very nice and expertise-filled layout of for stock options. A great many of entrepreneurs are at a loss in terms of how to deal with options. I think the most important part of what you outlined is categorizing employees. Once that vital part has been done, it’s easier to determine share-distribution.

  • Sean Mel says:

    We need a simple model to help us properly slice the pie. It needs to be flexible and fair. By fair I mean it needs to give each founder what they deserve. And by flexible I mean it needs to adapt over time to re-allocate the startup equity so that the distribution stays fair until the fledgling company takes flight. check out Mike Moyer’sbook slicing pie it talks about 50/50 share and how to divide it through his grunt calculator.

  • John Elbaum says:

    That’s some nice input on stock options. I never realized how much thought needs to be put into it.
    I find that many entrepreneur companies use stock options also as a means of keeping new employees from jumping ship or being head-hunted for highly seeked positions.
    They offer a certain number of options, but state that these options can only be exercised within a year (or other timeframe) after the IPO, or depending on how long the employee has been with the company. This makes it financially worthwhile for the employee to stay at the company, even if a competitor offers more attractive financial compensation.

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