What is an employee stock option plan startup? Stock option plans are an immensely popular way of motivating, attracting, and retaining employees, especially when the company is new and is unable to pay lucrative salaries. A stock option plan provides the company with the flexibility to award stock options to officers, directors, employee, consultants, and advisers, granting these people with the option to purchase stock in the business.

Valuing Stock Options for Startup Employees: Introduction

It's quite common for those who have been offered positions with startups to be given stock options to make up for low or modest salaries. Startup companies are known for aligning investor, manager, and employee incentives. When the business does well, so do the employees. Sometimes, employees overvalue their stock options, causing great disappointment when the business goes public or is acquired.

What Are Stock Options?

A stock option is a financial instrument and a privilege, sold by one party to another, which gives the buyer the right, but not the obligation, to sell or buy an underlying asset at an agreed-upon strike price within a certain period of time. The strike price at which the options are granted is usually the current market price. The time value of a stock option is determined by two factors:

  • The volatility or risk related to how much the price of the stock may fluctuate.
  • The length of time that the option may be exercised.

The greater the length in time to exercise, and the higher the volatility, the more valuable the option.

What Are Stock Options For?

Stock options are granted to employees for three main reasons:

  1. Compensation: Startups cannot usually afford to pay lucrative salaries to highly skilled employees. To make up for this, companies offer stock options to decrease the spread between the cash salary and the full market salary.
  2. Align incentives: Employees tend to work harder for investors when their motives are better aligned.
  3. Retainment: Stock options will usually vest for multiple years. During this time frame, turnover should be lower because employees are persuaded to stay with the company until they're able to exercise the options. Stock options allow businesses to compensate and attract talented employees by tempting them with lucrative paydays.

What Are Stock Option Plans?

Employee stock options allow employees to take part in the company's success without requiring the company to expend precious capital during the startup process. In fact, employees are usually required to pay the exercise price for the options, which helps to contribute to the company's capital.

The most significant disadvantage of stock options for a business is that it may cause a dilution in the other stockholders' equity after the options have been exercised. For employees, the main drawback is that if they work for a private company, there may be a lack of liquidity when they want to sell the option.

Prior to going public, the options will not be equal to cash because there's no market to actually sell the options. If the company doesn't grow, the options may become worthless over time. Stock options are appealing to employees because so many people have become millionaires through the use of them, and businesses like to utilize them because it keeps their employees motivated.

What Are Stock Options Worth?

The value of a stock option is the sum of its time value and intrinsic value. Upon being granted, the intrinsic value of the options is zero and all their value is time value. Upon being issued, the options usually have no intrinsic value. This is because the company is usually very young and probably not generating enough revenue to cover expenses. At the time the stock options are exercised, the approximate value is essentially equal to the current market price of the stock.

Making the Assignment

How many employee stock options should be granted? The assignment of stock options is usually a five-step process:

  1. Calculate how much compensation should be provided to the role.
  2. Calculate the amount of cash compensation that should be included.
  3. Forecast how long the stock options will cover the cash payment shortage.
  4. Calculate the strike and value price of the stock options.
  5. Calculate the total number of stock options to be granted to the employee.

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