Strike Price Startup: Everything You Need to Know
A strike price startup, or option pool, is an essential tool when it comes to a company's compensation armory.3 min read
2. Why Have Options?
3. How is the Strike Price Set?
A strike price startup, or option pool, is an essential tool when it comes to a company's compensation armory. A scheme that has an option that's well-designed will contribute to attracting and keeping crucial talent and making sure the value is fairly attributed to anyone who contributes. An option is a type of contract that allows the holder a right while not being an obligation to buy a certain number of shares of a company at a certain price on or prior to a specific date.
Understanding Startup Option Pools
A certain price is known as the strike price of an option and is related to a share's value at the date that the option grant gets made. These are made in the exception that the value of the specific share's price will increase as the business continues to grow and expand. When it has reached a point where the share price increases, every option granted is equal to the difference between what the share's price is at that specific time and the strike price it was awarded.
An option contract lets holders participate in the value that the business generates as if they were a shareholder when the strike price was lower but didn't have to move any capital.
Why Have Options?
Options can be offered as an incentive for employees of private and public companies. There are three main reasons they're used as a way to compensate employees, including the following:
- Reduces the cost of the company's compensation
- Reduces the principal-agent problem
- Removes any cash risk from employees
Early-stage companies are typically led by a CEO who has a large portion of the company's equity, as the companies aren't generally run or managed by shareholders. Instead, shareholders will give the authority to their managers, who are in charge of running a business on their behalf. Sometimes agents might act in their best interests instead of the interests of the company as a whole. Investors often like to see their company's managers incentivize with some options so they can align the interests of the managers and shareholders.
A manager is only rewarded when a shareholder is rewarded similarly. An option scheme will pay large dividends to a person but have an immediate cost to a business. Options that are granted over one percent of a company's equity will be worth almost $10 million to the person if a business exists as a unicorn. Granting an award like this to a senior employee wouldn't cost the business anything as far as cash cost goes compared to a bigger salary that may be required otherwise.
Getting the balance right is an art and is determined by the stage of the company and what the seniority is of the new hire. Options can also be used to give equity participation without having any cash exposure to the person they're awarded to.
How is the Strike Price Set?
An option's strike price is related to the company's value at the time of the issue date. It's usually the last round before the issue, but the business needs to agree on a share price valuation before they can grant options to employees without getting a tax charge. They need to discuss this with the local tax authority. In the United Kingdom, some schemes are available that provide favorable tax treatment in certain circumstances and these need to be carefully researched according to each circumstance.
If the real value of a cash negative company to a minority investor is either zero or low, tax authorities can accept strike price options that are under the last share price that the company paid. Options are a more efficient way to decrease the strike price, as not as many options need to be awarded a payout that's similar.
When awarding options, there are two trains of thoughts. The first is options are applicable to every employee and that a higher value is made by making sure they all have an ownership stake in what they're trying to create. The second thought is that the incentive's value shouldn't be sharply diluted and that bigger returns get generated when the value is mainly focused on key employees.
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