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Not optional. Understanding startup option pools

Martyn Holman

Investment Partner

An option pool, or an ESOP (Employee Share Option Pool) is a key tool in a company’s compensation armoury. A well designed option scheme will contribute significantly to attracting and retaining key talent and ensuring that value is attributed fairly to those that contribute. In this article we attempt to outline some of the critical considerations around establishing an option pool, particularly for those companies approaching a Series A investment.

Firstly, exactly what is an option?

An option, as referred to in the context of an early stage private company is a contract that gives the holder the right, but not the obligation, to purchase a specified number of shares of that company at a specific price on or before a certain date in the future. The specific price is referred to as the “strike” price of the option and relates to the value of the share at the date on which the option grant is made.

Option grants are made in the expectation that the value of the price of a given share will rise as the business grows and expands. At such point when the share price has increased, each option granted is therefore worth the difference between the price of the share at that time and the strike price at which it was awarded. This is demonstrated graphically in figure 1 below.

Fig 1. The value of an option with a £1 strike as the underlying share price changes

[1] At exercise. In public markets options are traded freely as a security in their own right with a value that is calculated by complicated “Black Scholes” models which are mainly a function of the underlying asset price, interest rates, and the time to expiry of the option itself.

As such, an option contract is a mechanism that allows holders to participate in the upside value generated by the business as though they became a shareholder at the lower strike price, but without having to deploy any capital.

Why options?

Options are used as an incentive mechanism for employees of both public and private companies. Options are used to compensate employees for three primary reasons:

  1. They serve to reduce the principal-agent problem
  2. They reduce the cash cost of compensation for the company
  3. They remove all cash risk from the employee

Let’s examine each of these in turn. Firstly, although early stage companies will likely be led by a Founder CEO who holds a good portion of a company’s equity, in general companies are not run and managed by shareholders. Shareholders (the “principals” in this discourse) delegate this authority to managers, or to use economist-speak, agents, who they pay to run the company on their behalf. However, in some circumstances agents may be motivated to act in their own best interests, rather than in the best interests of the firm as a whole. Investors therefore generally like to see managers of their company incentivised with options as an effective way of aligning interests of shareholders and managers - the manager will only be effectively rewarded when the shareholder is similarly rewarded.

Secondly, an option scheme can pay huge dividends to an individual but carry an insignificant immediate cash cost to the company. For example, options granted over 1% of a company’s equity would be worth nearly $10m to the individual if the business ultimately exits as a unicorn. Granting such an award to a senior C-level hire would however cost the company nothing in terms of immediate cash cost as opposed to a larger salary that might otherwise be required. Getting this balance right is of course a delicate art and depends significantly on the stage of the company and the seniority/criticality of the new hire.

Thirdly, options are used to provide equity participation without any cash exposure to the individual to whom they are awarded. Granting shares without payment would generally confer a value transfer to the employee who would then likely be liable at least for a “dry tax” charge i.e. a tax bill on a paper capital gain that cannot be realised at that time. New employees are unlikely to relish the prospect of being invited to invest significant capital in their new role in order to buy their share allocation when they know relatively little about the company they are joining. Options are a vehicle to provide effective share ownership and therefore upside participation without any of these complications.

So how is the strike price set?

The strike price of the option relates to the valuation of the company at the issue date. Often this is the last round price prior to the issue, but in order to be able to grant options to employees without them incurring a tax charge, the company will need to agree a share price valuation with the local tax authority, and the means by which the instrument will be treated for tax on eventual exit, for example with the HMRC in the UK. Some schemes are available in the UK (e.g. the EMI scheme) that provide very favourable tax treatment of outcomes in some circumstances, and should be researched carefully according to individual circumstance.

Given that by default the real value of a cash negative business to a minority investor is low or arguably zero, tax authorities may often accept a strike price for options which is below the last share price paid for the business, sometimes considerably so. Some investors are nervous about this type of discount, but they shouldn’t be. Options are more efficient the lower the strike price i.e. fewer options need be awarded for a similar ultimate payout.

Who should options be awarded to?

There are two primary trains of thought when it comes to awarding options. The first theory is that options are applicable to all employees, and that greater value is created by ensuring that all have an ownership stake in what they are helping to create. The alternative view is that the value of the incentive should not be diluted so sharply, and that superior returns are generated when the value is concentrated around key employees.

The reality of which model fits best is somewhat dependent primarily on stage of company. The European tech industry landscape has matured to the extent that the majority of people seeking roles in early stage startups now understand and value an options package in much the same way that anyone in Silicon Valley would do the same. At around 50 employees a company starts to mature to the extent that extending the options scheme to increasingly more staff probably has a diminishing impact, and options awards can generally be preserved for hires into specific or particularly impactful roles. Having said this, large publicly listed employers, particularly those in the US, use stock option grants widely to large groups of employees.

The amount awarded to individual members of an organisation does vary widely prior to Series A investment, but in our experience post Series A companies generally fall into the following ranges:

Non founder CEO        3 - 8%

C level executives        1 - 3%

Chairman                     0 - 3%

Independent NED        0.5 - 1%

Fred Wilson, the founder of Union Square Ventures and globally renowned VC blogger has written extensively on the subject of how much equity should be granted to management teams in this particularly useful article.

In summary, when deciding who gets what in terms of option equity awards it is useful to consider both the level of expected onward dilution (though often investors are willing to compensate for ESOP dilution by further awards in some circumstances) and the relative value that an individual can bring. Will hiring your new COO mean more than a 2% increase in valuation? Considering this pragmatic trade off may often help you to avoid destructive negotiations.

Terms of grant

Options are awarded to employees according to rules which are normally set out in a separate option agreement and scheme rules. Option agreements do not generally form part of the employment contract.

The main consideration is usually around how the option is “vested” over a period of time i.e. options generally do not accrue to the individual immediately, but rather over a specified period of time. This vesting period is commonly 4 years with the first year being a “cliff”. Under such an arrangement the employee would accrue no interest over options until the end of the first year, when 25% of the total would vest. During the subsequent three years the remainder would generally then vest equally over either months or quarters. Some schemes allow for “accelerated” vesting, where some or all of the options vest immediately at the point of exit. Such arrangements serve both as an incentive and as a retention mechanism to ensure that key employees are locked into the business.

Boards of private companies are usually granted significant discretion over the treatment of option grants to individuals in circumstances where individuals subsequently leave the business prior to an exit. A baseline will normally be created in the “Leaver Provisions” of the company Articles, and it is normal that somebody choosing to leave a company is treated as a “bad” leaver, often then forced to at least exercise his options i.e. purchase the underlying shares (in what is normally an illiquid, private company), sometimes effectively being required to relinquish them for no gain. The application of tight leaver provisions varies and there are obviously pros and cons to looser and tighter application. In general, Forward Partners favours a more generous application of leaver provisions in its investments as the critical requirement for early stage companies is the ability to attract the right talent at the right time, and we prefer more positive motivations to retain this talent.

What might a Series A investor require?

If you have not put in place an ESOP scheme prior to Series A investment, it is very likely that a Series A investor, if not a seed investor before them, will look to require you to provide for one in their investment terms. Their aim is for you to have set aside sufficient options to be able to attract and retain key members of staff as the business grows.

The total size of an ESOP scheme depends on a great many factors, not least the level of founder equity held by the senior team, the projected number of senior hires that the business will need to make to grow, and the stage the business is at. In general however, an option scheme in a post Series A invested company will generally represent 10 - 20% of the “Fully Diluted” equity of the business. “Fully Diluted” in this context means as a percentage of the number of shares that would be in existence assuming that all of the options over shares are exercised. For example, a business may have 80 “issued” shares and options in place over a further 20 shares - this would be an example of a company with an ESOP of 20% of the “Fully Diluted” share capital.

It is critical to ensure that you read term sheets carefully on this point. Often a term sheet will insist that the option scheme is created or topped up to a given level prior to the investment. Effectively this is requiring that the existing investors and founders take all the dilution for the additional shares. Looked at another way, it allows the new investors a discount to the value of the headline share price for the new shares that they are buying. The difference on dilution for existing shareholders can be meaningful as demonstrated in figure 2 below, a simplified example where £250 is invested in a business valued at £1,000 with the requirement that the option pool is maintained at 15% of Fully Diluted (FD) equity.

Fig 2. Illustration of the impact on dilution of a pre and post round option adjustment

 

In summary

A share option plan is a key component of the remuneration strategy for an early stage private company, these days perhaps even a hygiene factor. The technical aspects of a scheme will require some careful thought and professional advice. However, a well designed scheme helps align incentives of employees and owners, and at the same time provides potentially significant and therefore highly motivating returns with no cash exposure for either party.

Useful Links & Resources

Martyn Holman

Investment Partner

Martyn’s early career was spent as a consultant with the leading strategy consulting house, Boston Consulting Group. He has since developed a wealth of experience with technology based growth businesses and joined Betfair in its infancy as Director of New Ventures. Whilst at Betfair, Martyn founded and spun out LMAX Exchange, a leading multilateral trading facility for FX trading. During his time at LMAX, Martyn held the role of COO, driving market structure, product strategy, market development, commercial and international strategy and sales and corporate development. In 2012 Martyn joined Google as NPS Sales Operations North & Central Europe before joining Oxford Capital in 2013 where he led investment strategy. During his tenure, Martyn led investments and was Board Director for businesses including Linkdex, Outplay Entertainment, Kobojo, and import.io.

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