An option is a right to buy shares in the future at a fixed price. That fixed price is often referred to as the ‘exercise price’ or the ‘strike price’.
The reason an employee is motivated by holding an option, is that the bigger the difference between the current value of shares and the exercise price, the more valuable the option, and so employees are encouraged to maximise the value of the company.
Obviously, it’s in the interests of employees to have the lowest possible exercise price, but someone loses out: the founders.
Why the exercise price is about fairness to founders
Founders typically take on huge risks and make enormous contributions to start a business, normally at no cost to the company. Their contributions typically come in the form of:
- interest free loans or strings-free seed investment
- the business concept and intellectual property
- their time, effort and expertise.
These three contributions each have a value. If options are given to employees with a zero exercise price, they are getting some benefit of the founders contributions, regardless of whether the new joiner themselves have contributed. Fairness can be restored by requiring new employees to pay a purchase price on their options equal to the contributions of the founders.
How to link the exercise price to founders’ contributions
It is possible to put a value on each of these contributions:
- interest free loans or strings-free seed investment: add up the amount of the capital provided plus the interest or return an external investor would require
- the business concept and intellectual property: value the whole company
- their time, effort and expertise: value of the whole company at the point the employee joined
A worked example on how to set the exercise price
John and Mary create a consulting business. They invest £500,000 in the form of interest free loans. They work for little or no salary for 3 years. Their accountant values their business at £600,000 at the end of year one, £1.2m after year two and £2.4m after year three. Sarah joins the company and makes a significant contribution to the business. John and Mary want to encourage Sarah to stay with the business, by offering Sarah an option over 300 shares, equal to 3% of the company.
Suppose Sarah joins in year 1, before it is valued. John and Mary think it is fair that Sarah only benefits from her option once the company has increased in price above the amount they have invested. So they give her an option with an exercise price of 3% of the amount they’ve invest plus a return. John and Mary estimate this to be £500,000 plus 20% (to reflect the additional return that would be required by an external investor), so £600,000. Each share is 1%, so that results in an exercise price of £60 per share.
Supporse Sarah joins in year 2, but John and Mary don’t award her an option until year 3. As Sarah has been contributing from year 2, but no earlier, John and Mary decide to set the option price by reference to the value of the company in year two: £1.2m, resulting in an exercise price of £120 per share.
Supporse Sarah joins in year 3. Sarah hasn’t contributed anything so far, so John and Mary belive the entire value of the business (£2.4m) is attributable to them, and Sarah should only benefit above that value. So her option exercise price is set to £2.4m, resulting in an exercise price of £240 per share.
Just in case you got bogged down with the numbers above, just remember this:
Setting the exercise price is about fairness between founders and employees. Set the exercise price at the share price, measured when the employee started to make a contribuition. That will be fair by everyone.
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