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!
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
Dr. 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