What is an option?
An option is a contract that gives the holder the right to buy a specified number of shares at a specific price on/before a particular date. The specific price is referred to as the ‘strike’ price of the option and relates to the value of the share at the date on which the option grant is made.
Option grants are made in the expectation that a share price’s value will rise as the business grows. When the price has increased, each option granted is worth the difference between the price of the share at that time and the strike price at which it was awarded (see chart below).
[1] In public markets, options are traded freely as a security in their own right with a value that is calculated by complicated “Black-Scholes” models which are mainly a function of the underlying asset price, interest rates, and the time to expiry of the option itself.
An option contract is a mechanism that allows holders to take part in the upside value generated by the business as if they became a shareholder at the lower strike price, but without having to deploy any capital.
Why are options used?
Options are used as an incentive mechanism for employees of public and private companies. Options are used to compensate employees for three reasons:
- They reduce the principal-agent problem
- They reduce the cash cost of compensation for the company
- They remove all cash risk from the employee
Although early-stage companies are usually led by a founder or CEO who holds a good portion of company equity, firms are generally not run by shareholders. Shareholders (“principals”) delegate this authority to managers – or to use economist-speak, agents – who they pay to run the company on their behalf.
Sometimes, agents may be motivated to act in their own best interests rather than those of the firm. So, investors like to see company managers incentivised with options as an effective way of aligning interests of shareholders and managers. That way, the manager is only effectively rewarded when the shareholder is.
An option scheme can pay huge dividends to an individual but carry an insignificant immediate cash cost to the company. For example, options granted over 1% of a company’s equity would be worth nearly $10m to the individual if the business ultimately exits as a unicorn.
Granting such an award to a senior C-level hire costs the company nothing in terms of immediate cash cost, as opposed to a bigger salary that might be required. Getting this balance right is a delicate art and depends significantly on the stage of the company and the seniority of the new hire.
Options are used to provide equity participation without cash exposure to the individual to whom they are awarded. Granting shares without payment generally confers a value transfer to the employee. They’re then liable for a ‘dry tax’ charge, such as a tax bill on a paper capital gain that cannot be realised at that time.
New employees are unlikely to want to invest capital in their new role to buy their share allocation when they know relatively little about the company they’re joining. Options are a vehicle to provide effective share ownership without these complications.
How is the strike price set?
The strike price of the option refers to the company valuation at the issue date. This is often the last round price prior to the issue. To grant options to employees without incurring tax charges, the company needs to agree a share-price valuation with the local tax authority. They must also agree the means by which the instrument will be treated for tax on exit, like with the HMRC in the UK. Some schemes are available in the UK (such as the EMI scheme) that provide favourable tax treatment of outcomes.
The real value of a cash-negative business to a minority investor is low, or arguably zero. So, tax authorities may accept a strike price for options below the last share price paid for the business, sometimes considerably so. Some investors are nervous about this type of discount, but they shouldn’t be. Options are more efficient the lower the strike price. And fewer options need to be awarded for a similar ultimate payout.
Who should options be awarded to?
There are two primary trains of thought when it comes to awarding options. The first is that options are applicable to all employees, and greater value is created by ensuring all have an ownership stake in what they’re creating. The other view is that the incentive value shouldn’t be diluted so sharply, with superior returns generated when value is concentrated around key employees.
The reality of which model fits best is dependent on the stage of the company. The European tech-industry landscape is a mature one. And most people seeking roles in early-stage startups now value an options package like anyone in Silicon Valley does.
Once a company hits 50 staff, extending the options scheme further has a diminishing impact. Options awards can be preserved for hires into specific or particularly impactful roles. But large publicly listed employers, particularly those in the US, use stock option grants widely to large groups of employees.
The amount awarded to individuals in an organisation varies widely prior to Series A investment. But in our experience, post-Series A companies generally fall into the following ranges:
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When deciding who gets what in terms of option equity awards, it’s useful to consider the level of expected onward dilution and the relative value an individual can bring. Will hiring your new COO mean more than a 2% increase in valuation? Considering this pragmatic trade-off may help avoid destructive negotiations.
How are options awarded to employees?
Options are awarded to employees according to rules normally set out in a separate option agreement and scheme rules. Option agreements do not generally form part of the employment contract.
The main consideration is around how the option is ‘vested’ over a period of time. Options generally do not accrue to the individual immediately, but over a specified period, usually four years. Under such an arrangement, the employee accrues no interest over options until the end of the first year, when 25% of the total vests. During the subsequent three years, the remainder vests equally over either months or quarters.
Some schemes allow for accelerated vesting, where some/all options vest immediately at the point of exit. Such arrangements serve as an incentive and as a retention mechanism to ensure key employees are locked into the business.
Boards of private companies are usually granted significant discretion over the treatment of option grants to individuals. This is particularly the case in circumstances where people subsequently leave the business prior to an exit.
A baseline will normally be created in the ‘Leaver Provisions’ of the company Articles. It’s normal that somebody choosing to leave a company is treated as a ‘bad’ leaver, often forced to at least exercise their options. They will need to buy their underlying shares (in what is normally an illiquid, private company), sometimes effectively required to relinquish them for no gain.
The application of tight leaver provisions varies and there are pros and cons to looser and tighter application. In general, Forward Partners favours a more generous application of leaver provisions in its investments. That’s because the critical requirement for early-stage companies is being able to attract the right talent at the right time. We prefer more positive motivations to retain this talent.
What do Series A investors require?
If you don’t have an ESOP (Employee Share Ownership Program) scheme prior to Series A investment, it’s likely Series A investors will insist on one. The aim is for you to have set aside sufficient options to be able to attract and retain key members of staff as the business grows.
The total size of an ESOP scheme depends on many factors. These include:
- the level of founder equity held by the senior team
- the projected number of senior hires that the business will need to make to grow
- the stage the business is at.
In general, option schemes in post-Series A invested companies generally represent 10-20% of the Fully Diluted (FD) equity of the business. In this context, this means a percentage of the number of shares in existence, assuming all options over shares are exercised. For example, a business may have 80 issued shares and options in place over a further 20 shares. This would be a company with an ESOP of 20% of the FD share capital.
You must read term sheets carefully. Often, such sheets insist the option scheme is created or topped up to a given level prior to investment. Effectively this requires existing investors and founders to take all the dilution for the additional shares. It also allows new investors a discount to the value of the headline share price for the new shares they are buying.
The difference on dilution for existing shareholders can be meaningful as demonstrated in the diagram below: a simplified example where £250 is invested in a business valued at £1,000 with the requirement that the option pool is maintained at 15% of FD equity.
The impact on dilution of a pre- and post-round option adjustment.
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In Summary.
A share option plan is a key component of the remuneration strategy for an early stage private company, these days perhaps even a hygiene factor. The technical aspects of a scheme will require some careful thought and professional advice. However, a well designed scheme helps align incentives of employees and owners, and at the same time provides potentially significant and therefore highly motivating returns with no cash exposure for either party.
