HBS OPTION COMPENSATION WORKSHOP

Professor Brian J. Hall

February, 2001

© Brian J. Hall

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

Underwater Options

Value

$.50

$1.50

Strike Price

Current Stock Price$.30

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

Stay indefinitelyOption Grant at: 1 2 3 4 5 6 7

V V V V0

1

2

V V V V

V V V V

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.

Answer if you might want the job: Reframe the question--”Do you really like the company?”

“Well, of course, like all decisions, I would want to take some time to make a well-thought-through decision, but I am extremely excited about the company….What I am most excited about is X, Y, and Z.”