Startup: Stock Option Planning

How to prepare a good plan for granting stock options to employees in Startups.

Following are Four steps in Planning and Distribution of Stocks in Startups.

Lay the foundation

(A) Forecast all the rounds of venture capital you will need up to the day you go IPO.

You will need several rounds of financing, typically three in three years. It can be several more. Life science requires at least twice that number of rounds. The first two financing events are the Seed Round and Round A. The third is Round B. The naming is confusing, I agree. Just be clear and understand what each round is intended to accomplish. Each round needs the following information:

• Pre-company valuation in millions of dollars
• Cash to be raised this round
• Pre-company number of shares. This includes stock options.
• Ignore for now the difference between common and preferred shares.

With this information you can calculate the number of shares to sell the investors.
Now you have the total number of shares of the company: founders, employees and investors.

(B) Forecast all the employees you need up to the day you go IPO. Use as much detail as you can. Work from CEO to VP to Director to Manager to Employee.

(C) Do your first estimate of how many shares you will need for your stock option grants. This becomes your stock option pool. For now, ignore the cost of the stock per option per share.

(D) Add the stock option pool shares to your total shares of the company. This includes founders, stock options and investors and together equals the total shares.

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Classify employees

Classifying the employees. I hope you have at least guessed at the numbers for Step 1 (see yesterday’s blog). Guessing is what serial entrepreneurs do. Then they modify their initial estimates. That is how they build their plans. It is like shaping a lump of clay into a beautiful statute.

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Classify Your Employees

• Pick layers of employees. For instance: CEO, Vice President, Director and Employee. Each layer is often named a classification.
• Add the layers to your forecast model. Use Excel or equivalent spreadsheet.
• Forecast the number of employees for each layer. Do it for each of the first 24 months and each year thereafter, up to the day you plan to go IPO.

Now you have your company’s employee forecast. Congratulations, you are already ahead of 95 percent of the rest of the startup CEOs who are competing against you for venture capital. You will look very professional when compared to them. The investors might even think you know what you are doing!

Note that with this classification it is easy to begin to add wages to your financial forecast. That will account for 60 to 80 percent of your costs. More detail gives you a higher quality forecast. And you look even sharper to investors.-

Price the stock option per employee

To understand this you need to grasp how to structure the capital of a world-class venture backed startup.

CAPITAL STRUCTURE

• Common stock goes to employees and preferred stock to investors. The price per share of the common stock starts on day one equal to one tenth the price of the preferred stock. That gap will close year by year as the day for IPO approaches. For more details on what is going on here, see Chapter 9 of High Tech Start Up.
• Form a simple legal corporation not a partnership. LLCs and S corporations and others get you into blind alleys and will eventually trigger intellectual property, tax and stock option messes that are terribly hard to repair.
• Get an experienced lawyer to set up your capital structure. Mistakes are costly.

COST PER SHARE

• Start pricing each round of preferred stock. As noted in Step 1, you need a plan for each round of stock sold to investors, year by year. Calculate the price per share of preferred. This is what is used to determine the value of your company.
• Price the common shares. Gradually close the gap between preferred shares up to the day of IPO. This will be the strike price, the cost per share to the employee when they exercise the stock option (buy shares).

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Test the market
The final step is to determine how rich each employee should expect to be on the day of the IPO. With an IPO value per share (Steps 1 and 3) you can then calculate the number of shares to grant to each employee. To do that you need to know your local labor market, especially how much wealth it takes to attract the people you plan to recruit. Here are things you need to do:

FIRST TASK

• Dig to discover the wealth people expect to earn on IPO day. That requires knowing both wages and stock wealth requirements for each class of employee. You learn that by spending time talking to recruiters, lawyers, accountants, human resource managers, and doing your job as a manager in a real corporation. That on-the-job experience will reveal what IPO wealth targets are expected by the talent your startup needs. “A vice president of engineering will expect something like $10 million in today’s market for startup talent for a company in this early phase of its growth” is what you will end up concluding.
• Add the wealth target to each classification of employee. Add the dollars of wealth at IPO per employee to each class of employee, the classes you set in Step 2. Yes, there will be a range of wealth expected. For now, use a single number. That makes your task easier. You can add highs and lows around the number later.

• Calculate the number of shares for each employee and add them up. With the dollars of wealth per employee times the number of employees in each classification, take the price per share at IPO time (see Steps 1 and 3), and divide it into the dollars of wealth per person to get the number of shares for the stock options. Add all the shares up and you have the total you need for your stock option pool.

When you have completed this task, you can calculate a table per year of the percent of the company each employee will get each year. That is the shortcut, the end point, used to negotiate during recruiting. “The vice president of biz dev will get 1.2% of the company” is what is meant by this.

SECOND TASK

• Use risk reduction to modify the number of shares granted each year for each classification. A director of product marketing joining in year three will get fewer shares than if he joins in year one. A growing startup will reduce risk each month as it makes progress to IPO date. Less risk means less stock per option grant. Reduce the number of shares following the price per share curve you got when you sold stock to investors. This will alter the total number of shares in your option pool, most likely greatly reducing the number required. Alter your plan accordingly.

• Set the strike price for each option each year. The price per share will be projected to grow each year so the strike price will also grow each year. It will rise faster for common stock than preferred stock and gradually close the gap, rising to the same price as preferred stock by IPO day. In the early days of your startup it is common to increase the strike price per month during the first twenty four months.

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