Tag Archives: motivation

Which Way to Puchowich

Why Grant Options Early?

During an interview with a solar panel manufacturing startup in Vietnam, the CEO and co-founder lamented about high employee turnover.

He asked for advice on retaining employees and I suggested he consider granting stock options. These golden handcuffs would motivate his employees to stay because the agreement could result in a significant upside for them financially.

His response was one I’ve heard before, “me and my two brothers own the entire company. We don’t want anybody else to own any part of it. Maybe when the company gets larger we might consider granting options to employees, but certainly not now when the options could become so valuable.”

Many entrepreneurs fear loss of control. However, by motivating employees with shared ownership, you actually increase the likelihood of everyone succeeding.  Let’s look at the tactical side of options to better understand the positive role they play in the psychology of employees.

How Does an Option Work?

When you grant an option to an employee (aka the grantee or optionholder) to purchase n shares of the company, you are telling the employee that s/he may purchase n shares at some point in the future (usually at any time over the next 5 years) at a fixed price (called the strike price) that is defined today.

By regulation, that strike price must be close to today’s fair market value of the stock. See this great article by Morse Barnes-Brown Pendleton, PC, to learn about determining strike prices.

An option grant should never be an oral agreement; it should always be in writing and backed up with a previously approved formal option plan.

What Are Options Worth?

Let’s say an employee receives a grant of 50,000 shares with a strike price of $.20 per share. Furthermore, let’s say that the company’s current plan calls for growth (revenue and profit) and the sale of additional shares (e.g., via investments), resulting in the company being valued at $25,000,000 in 3 years with a total 6,250,000 fully diluted (i.e., outstanding shares plus all options exercised) shares.

And finally, let’s assume that the company actually achieves all its goals and the above plan becomes reality.

After 3 years, the employee could exercise his/her option, purchase the 50,000 shares at $.20 per share at a total cost of $10,000. Then, assuming the shares are liquid, s/he could immediately sell those shares at their current value of $4.00 per share (i.e., $25,000,000 divided by 6,250,000), and receive a check for $200,000.

So, at first glance, one could argue that this option was “worth” $190,000 ($200,000 minus $10,000) or $3.80 per share. But actually that’s the employee’s profit resulting from exercising the option and then selling the shares.

The actual “value” of a stock option is influenced by many factors:

  • The strike price and the expected growth of the company (the two factors shown above)
  • The probability that the company will achieve the expected growth
  • The probability of a total loss
  • The time value of money

Most entrepreneurs need to understand how to assign a strike price and the mechanics of how options work; they do not need to understand option valuation theory but if you really want to learn about it, the place to go is Black-Scholes.

Why Grant Options to Employees?

An employee who has options has the potential to receive a large sum of money if the company does well and the company experiences a liquidity event and the employee stays with the company.

The above is part of a formula for motivating employees to work hard (to help the company do well) and to stay with the company.

One of the best aspects of granting options to employees is zero risk:

  • If the employee chooses to not exercise the option, it costs her/him nothing
  • If the employee chooses to leave the company before exercising the option, the options return to the option pool.

Why Grant Options Early?

The spread between the strike price of an option and the market price of the share at the time the option is exercised determines the profit received by the employee. We usually talk about this spread in terms of percentage profit (1900%) or multiple (19x), as opposed to a simple dollar amount ($3.80).

The percentage profit is usually proportional to the rate of growth of the company. The faster revenue and profit growth for the company during the period of the option, the higher the percentage profit (in general!) for the optionholder.

As a general rule, a company’s revenue and profit can grow as a percentage of its previous year most easily during its formative years. After all, it is easier to grow 200% when revenues are $200,000 than it is to grow 200% when revenues are $20,000,000.

Therefore, granting an employee 1% of the company’s outstanding shares as options when the company is tiny will result in a much more valuable reward to the employee than granting that employee the same number of shares a few years later. More reward means more motivation and more long-term commitment.

And notice that as a founder, you “lose” the same number of shares either way!

Summary

Many entrepreneurs fear loss of control. However, by motivating employees with shared ownership, you increase the likelihood of company success. And success is what entrepreneurs should be striving for.

Offtoa lets you model stock options for employees so you can easily see how much dilution results for founders and investors.

About the Author

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

In case you were wondering, when I got to the “Rudzensk and Puchowich Crossroads,” shown in the photo, I turned right and headed 7 km toward Puchowich, the village where my grandfather grew up.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.

 

 

 

Photo credit: “Rudzensk and Puchowich Crossroads,” Belarus © Alan M. Davis 2006

 

Botswana Truck

Are YOU a Good Risk to be an Entrepreneur?

During the past 30 years, hundreds of people have asked me, “I’ve got this great idea for a product. All I need is funding. Will you help me?”

As I search through online forums, I see similar pleas over and over again, “I have this great idea for a new app. Will you help me build it?”

Kickstarter and similar venues are full of great ideas that need money.

Let’s assume that you have a great idea. Will adding money be sufficient to create success? Or are there other ingredients that make a business successful? The answer of course is that building a profitable business requires more than a great idea and money!

It includes attributes of the market, the industry, your background and skills, and the rest of the team’s background and skills, to name just a few. But let’s focus right now on just YOU.

Are you a good risk as an entrepreneur? Do you have what it takes? Should others have the confidence in you to bet their money on you and your company? Here is a list of qualities that experienced investors will be looking for from you.

1. Are you 100% committed?

Assuming that you are looking for others to invest their money in your business, they need assurance that you are completely committed. After all, when things get tough (and they will), you should not find it easy or comfortable to simply walk away from the business.

To demonstrate commitment, you need to show you have some kind of skin in the game. This can be done in many ways. For example, quitting your day job. Taking out a second mortgage on your home. Putting your retirement savings into the venture. Using personal credit card debt to partially fund the company. Working 60 hours a week for the new company while working your day job.  All of these demonstrate commitment.

If you don’t show commitment, you don’t have what it takes, and you should not be surprised if others see you as a poor risk.

2. Do you surround yourself with excellence?

Startups require an enormous breadth of skills. As an entrepreneur, you need to be confident enough in yourself to bring on board your team the absolutely very best talent that compliments your skill set. You do not have all the skills necessary to run a company by yourself. Nobody does. Whatever talent you are lacking (e.g., law, accounting, sales, marketing, engineering, product development), you need to hire the absolutely very best!

If you are afraid that hiring somebody “better than you” will somehow erode your position, you probably don’t understand the role of a corporate founder. If you are afraid to hire the best, don’t expect others to invest in you. You don’t have what it takes.

3. Are all the requisite skills covered?

In the previous section, I talked about the fact that no single individual can possibly have all the requisite skills to run every aspect of a company. So what are these requisite skills? Among others, they include:

  • Product development
  • Sales
  • Marketing
  • Accounting
  • Finance
  • Law
  • Leadership
  • Manufacturing
  • Quality control
  • Operations

And each of the above has multiple dimensions that sometimes require multiple individuals (unless you are fortunate to find individuals whose skill sets span the dimensions). For example, within marketing, there is SEO, website development, marcomm creation, lead acquisition, branding, and so on.

Of course, some of these areas are easily outsourced (e.g., law and accounting). And others can easily be deferred until the company grows.

If you are going after serious investor funding (e.g., from angels or VCs), you will need to have all these areas covered, or at least make it clear that you understand that you will need to quickly fill any vacant positions.

4. Have you or your team “been there before?”

Experience running a startup arms you in a way that cannot be replicated by books, mentorship, and research.  These are important too but experience is the best teacher. Regardless of whether that company was ultimately successful and not, certain patterns repeat themselves in every company. Investors do not like seeing their money squandered while first-time entrepreneurs learn lessons.

If you are a first-time entrepreneur, you might think that you have no chance to secure funding. That is not at all true. The solution is to build your team and make sure the team includes individuals who have been there before. Consider “having been there before” as just one of the many diverse set of skills one needs on the team.

Personally, I served key roles in two startups. First I was a non-founding, vice president for a company that eventually had an IPO. Second I was a founding member of the board of directors for a company that was acquired by a publicly traded company. By the time I launched a startup as the CEO, I clearly had “been there before” even though I had not personally been the founder or CEO of either of the two earlier companies.

5. Are you a proven leader?

You may be the perfect founder for a company, but may have none of the skills required of a leader. In such a case, you might want to serve as the chief technical officer (CTO) for the company and allow somebody else to run the company.

You will still be a significant shareholder, but the company will be more attractive to investors and you’ll end up with a smaller piece of much larger pie than a large piece of a very small pie.

6. Are you motivated by the right things?

Outside investors (as well as potential colleagues) are going to be assessing what motivates you to start a company. It has to be for the right reason. Or at least it must be for a reason that is compatible with the investors.

Some of the likely wrong reasons to start a company are power and ego gratification. A good reason to start a company is a sincere desire to satisfy a customer problem. Wealth creation might be okay if it is not the only reason, and it isn’t just for yourself.

I remember asking the founder of my first startup company what his goals were; he responded, “I plan to become very rich, and I hope as many people as possible become very rich along with me as we endeavor to solve the problems that the customers have” I like that!

Summary

Many aspiring entrepreneurs who lack funding blame investors (or lack thereof) for their failure. In many cases, however, these individuals have at least two options:

  1. They can improve their chances of funding by changing their own skills, attributes, and attitudes.
  2. They can figure out how to bootstrap their businesses. By doing this they expend their energies slowly growing their businesses instead of complaining about the lack of funding.

If you have what it takes to be an entrepreneur, the next step is to create your pro forma financial statements. If you want to learn how to generate pro forma financial statements automatically from your business assumptions, check out www.offtoa.com.

About the Author

Alan DavisDr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., a SaaS company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com.