It's All In The Equity

Cash is one thing (you can't pay the rent or the mortgage with stock options) but if you want to see the ears really prick up, start talking about equity. Candidates and clients alike continuously ask us about the fairness and competitiveness of option packages. The truth is that because of the numerous variables involved, it is impossible to give an adequate answer. The fairness of any option grant is extremely subjective.

Let's start with a few basics. An employee cannot immediately exercise his/her options until the options are "vested." The employee must earn the right to exercise his/her options over time. This helps employers retain employees.

In the Silicon Valley, most option grants given to a new employee vest over a four-year period with a one-year "cliff." The "cliff" means that the employee will not be entitled to exercise his/her options (purchase the underlying stock) until the end of the first year, at which time he/she can exercise 25% of the original grant. The options then vest at a rate of 1/48th a month thereafter. While four year vesting with a one-year cliff is typical in the Silicon Valley, companies can choose to have their options vest in a variety of different manners.

Options are granted at an exercise price equal to the stock's fair market value at the date of the grant. This is often referred to as the "strike price" and is the price per share an employee will have to pay to purchase the stock underlying the option. If the company is publicly traded, it is easy to ascertain the fair market value--it's whatever the stock is trading at when the grant is made. For prepublic companies, fair market value is determined by the company's Board of Directors, who take into account a variety of factors including recent financings. The hope is that the fair market value of the stock keeps going up so that by the time an employee exercises his/her option, the current fair market value is much higher than the strike price.

The real question on everybody's mind is what is a fair number of shares to be given on the initial option grant. For potential employers, the answer to this question is relatively straightforward. The option grant should be within the range that all other employees at the same level recently received. For example, if we're talking about a VP, General Counsel level position, the attorney should receive options in line with the other VPs who were recently brought on board. But, not all VPs are created equal. The attorney needs to keep in mind that his/her position, while important to the company, may not be perceived to be as critical as the CFO, VP of Sales, or other strategic VP level positions. Attorneys should never expect a company to skew their option grant to accomodate any one employee.

Ascertaining the fairness of an option grant from a candidate's perspective is not a cut and dry analysis. There are many variable involved including the number of shares outstanding, the stage of development of the company, how successful the company will be, how much dilution the candidate may incur in the future, and what other employees of the company have received. In general, if a candidate joins a company earlier in its development, he/she will receive a larger grant (because he/she is taking a greater risk) at a lower strike price (because the fair market value is lower). Candidates should certainly do their homework and attempt to collect comparable data about option packages from other similarly situated companies, and they should certainly try to determine if "smart" money is backing an early stage company. But because no one has a crystal ball, at the end of the day candidates have to rely on their gut to decide if they are getting a fair deal. Relying on an option grant that represents a certain percentage of the company only works with early stage companies and lawyers are usually brought in at a later stage.

Our advice to candidates has been to run their own analysis, multiplying the option grant by what they think the company's potential price per share could be, less the strike price. This is by no means a fool proof analysis, but it will give a candidate a sense of how he/she feels about the company. If the analysis gives a number that is lower than expected, it can demonstrate one of two things: either that the candidate's expectations of the company's potential are not very high; or the grant is too low.

 

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