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 and investors.
Why the exercise price is about fairness to founders and investors
Founders and investors 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:
- cash for equity or loans
- the business concept and intellectual property
- their time, effort and expertise.
These contributions each have a cost, but they are unlikely to be immediately reflected in the value of the business.
If options are given to employees with an exercise price below the cost of these contributions, they are getting a ‘free ride’ – the benefit of something they haven’t earned.
Fairness can be restored by requiring new employees to pay an exercise price on their options equal to the contributions of founders and investors.
An (extreme) illustration of the unfairness
Suppose a founder gifts £500k to a startup, and gives an option over 10% of the company to an employee, with a total exercise price of £1. Due to difficult circumstances, the cash is spent, and the business is then sold for £500k.
The optionholder exercises the option immediately before the sale, so they pay £1, and then sells their shares for £50k. The founder only has 90% of the shares, which they sell for £450k. The optionholder hasn’t created any growth, but gets an undeserved £50k.
This is an extreme example, but it emphasises the principle: granting an option at an undervalue is a direct transfer of wealth from founders / investors to the optionholder.
Let’s change the facts a little – say the business is sold for £1m. The founder gets £900k, the optionholder £100k. But the reality is that the founder put in £500k and only got £1m back – so there has only be £500k of growth. Even on a slightly more successful sale, it’s clear that, where the exercise price is less than the contributions of founders and investors, the optionholder is getting some value they didn’t contribute to.
Why does the market value not reflect contributions?
The amount investors invest for a minority stake in a business does not necessarily (or even typically) equal market value for that business. Just because investors may have subscribed for 10% or 20% of shares in a company, that does not mean there is a buyer for 100% of the company at the same price.
Businesses (ignoring investment funds or financial services businesses) are typically valued on the basis of earnings for the purpose of a sale of the whole business. It takes time for the contributions of founders and investors to bear fruit in the form of higher earnings and a higher valuation.
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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