How to Price Options?

  • By TLV Partners
  • 12 Nov, 2017

This post is for entrepreneurs and will hopefully convince you that keeping the price of your Options low is the rational thing to do.

(Understanding Options is mandatory in an industry which makes use of Options as a compensation mechanism. If you suspect you don’t fully understand Options I recommend reading our previous blog post: ( Options - Basic Terms ).

Recently, I’ve witnessed that lawyers and some board members pressure entrepreneurs to increase the exercise price for employee Options. This post is meant for entrepreneurs and will hopefully convince you that keeping the price of your Options low is the rational and right thing to do.

Options serve as a tool to reward employees for the years they have devoted to the company. Most of your employees could easily work for other companies, and in some cases receive a higher salary and more benefits.

The Options’ exercise price can have a substantial impact as the company matures, thus when debating setting that price, there are several considerations that need to be taken into account:

  • There are different rules in the US and in Israel regarding Option pricing. For US employees you have to, due to US tax regulation demands, price the Options based on a 409A valuation, which is a formal report that tells you the current fair market value of your company's common stock. In Israel the company has more flexibility in setting the Options exercise price. So your first dilemma is whether to have one price for all your employee Options or not.
  • Employees that leave your company before an exit occurs can choose to exercise their options. Typically the employee Stock Option agreement will have a clause setting a defined term (such as four weeks) from leaving the company, during which an employee may exercise his or her Options - or lose them. Unexercised options return to the pool of unallocated options. In some cases you might prefer to keep these options to avoid extra dilution. If the price of the Options is too low, it will be a no brainer to exercise options upon leaving.
  • When employees exercise their options, whether through a cashless exercise in an exit, or upon leaving the company, the cash goes to the company. In some cases these amounts can be significant.

When considering the Options’ price one should not forget the core reason for giving options in the first place. The main driver behind options is to compensate and motivate your employees. In all of my recent exits, the founders were proud that tens of their employees received substantial financial reward for their contribution. Being loyal and taking care of your key employees (not just the VPs), is a critical part of startup culture. All other considerations should be viewed as secondary.

It is true that employees leave companies. In some cases a key employee departure can severely hurt the company. But even if you are disappointed that someone has decided to leave your company after 3-4 years, you should also remember that they devoted 3-4 years of their career to your company. Regarding the Option price, most people cannot afford the heavy financial risk when exercising their options. It is unreasonable to expect employees to risk tens of thousands of dollars on your company. The price to exercise Options should reflect belief, but in no way jeopardize your employees’ financial future.

With regards  to the money returning back to the company from employees exercising Options, this shouldn’t be a relevant factor. If your company’s future is dependent upon employees exercising their Options, you have bigger issues than pricing options. And when you sell your company, be generous and let your employees enjoy their options, they deserve it.

The last point is more tricky. The 409A usually results in an exercise price which is rather high, and the company has to use that exercise price for all employees with US citizenship. I personally believe that companies should differentiate between Options that are given to their Israeli employees - because they can. There are other considerations like taxes that substantially affect the value of Options in different countries. In each country you should review and decide on a mechanism that maximizes your employees’ benefit and return. Trying to account for all the different factors in order to create a unified policy will result in a less than ideal situation for everyone. Frankly, as long as you don't have hundreds of employees you can probably deal with 2-3 policies. Just ensure you properly explain the difference to your employees clearly.

To summarize, reward your employees, take care of them and together you will be able to achieve great things.


TLV Partners Blog

By TLV Partners 12 Nov, 2017

(Understanding Options is mandatory in an industry which makes use of Options as a compensation mechanism. If you suspect you don’t fully understand Options I recommend reading our previous blog post: ( Options - Basic Terms ).

By TLV Partners 05 Nov, 2017

A few months ago, a friend of mine left his position as chief architect at one of Israel’s most respected companies. After five years, he decided to start his own company, and left with the blessing of the founders and the board. “I have 0.5% in vested options” he told me excitedly. Naturally, I was happy for him.

Only two weeks later I received a worried sounding phone call from him: “We must meet, I need your help”. I set up a meeting for the next day.

After short review of his situation, I sadly recommended that he not exercise his options. The situation frustrated me so much that I felt compelled to write this post.

What are options?

Options, in its most basic definition, represent the right to buy shares in a company. If you received an option to buy a share for $1 and after four years the share is worth $20, your profit would be $19.

Startup companies give options to employees as part of their compensation package. The earlier you join the startup and the more senior you are, the more options you will receive.  Options vest over time, and usually there is a one year cliff followed by quarterly vesting. So if you received 100 options, you must stay in the company for at least one year to get 25 options. After that, every quarter over the following three years you will receive an additional 6.25 options.

Of course, you must wait for either an M&A or IPO to translate the theoretical profit into cash. And only if you still work for the company at the time of the exit will you realize this profit.

But what happens if you leave the company before an exit occurs? In that case, you must decide whether you would like to buy your vested shares at the exercise price or not. The exercise price is the price of the option.

But who decides what the exercise price should be? Well, to understand that, we must first understand who determines the price per shares of the company.

The price per share reflects the valuation of the company, and investors (the board) this with the company every time there is a new financing round.

After determining the price per share, the board moves on to determine the exercise price with the help of an outside consultant. The board usually recommends pricing the options at a discount to the current price per share. The discount reflects the preferences that the investors' shares have. Employee's options entitle them to buy common shares only. (If I’ve lost you, please read our previous blog post:  Participating Preferred? Not If You’re a Series A Investor ).

The sad story behind our chief architect’s stock options

Now let’s get back to our chief architect: Before he received his options, the company raised a round at a high valuation. The late stage investors received a 3x participating preferred preference. (It is common that companies provide investors with big preferences to increase valuation). Strangely, the board decided that the exercise price be identical to the price per share. Thus, our chief architect received an option to purchase common shares at an inflated price. In his case the discount on the options should have been around 70% from the price of the shares in the round.

Similar scenarios occur in our industry from time to time. Employees receive option grants, but find themselves disappointed at the exit. Unfortunately, many companies are hesitant to share information about their options with their employees. The obscurity around options, creates expectation gap, that can hurt everyone around the table. In many cases this obscurity is unnecessary, and companies are better off setting the right expectations from the start.


By TLV Partners 26 Oct, 2017

הדבר שאני הכי אוהבת ביזמות ועבודה בסטארטאפ הוא שכל שנה, פחות או יותר, יש תזוזה משמעותית של מרכז הכובד של החברה. מה שאומר שהעבודה שלי משתנה. בשנה מסויימת הפוקוס שלי היה על שיווק, באחרת על ניהול ובשנה אחרת על שיתופי פעולה. השנה היתה ללא ספק שנת פרודוקט. בשנה האחרונה למדתי, השתפרתי ושיניתי הרבה מתפיסות ניהול המוצר שלי.

למה פרסונות וראיונות משתמשים הם בולשיט?

אחת מקפיצות המדרגה הכי משמעותיות שהיו לי בשיווק היתה ההבנה שאנשים הם מורכבים, מאד. הרבה יותר מכדי שנוכל לצפות אותם.

אנשי שיווק אוהבים לשבת ימים על גבי ימים בחידוד הניסוח המדוייק של מה המוצר עושה, בשיפור המילים שיופיעו בדף הבית או באימייל למשתמשים. ההנחה הבסיסית היא שאנשים רוצים מוצר שיעזור להם לעשות X. בפועל, אנשים מונעים ממניעים משונים, עמוקים ומפתיעים – מה יחשבו עליהם האנשים שעובדים איתם, מה זה אומר עליהם, האם יש להם כוח ללמוד משהו חדש והאם זה משאיר להם מספיק זמן להתבטל בכיף.

בשיווק החיים קלים יותר. אם הנחת הבסיס היא שאי אפשר באמת לחזות אנשים, ניתן להריץ אינסוף טסטים, סוגי קמפיינים שונים, פוסטים בנושאים מגוונים ודפי נחיתה יצירתיים – ולבדוק מה עובד ומה לא.

במוצר אין את הפריבילגיה הזו. העבודה על כל פיצ׳ר היא מורכבת ו״יקרה״ מדי בשביל שלל ניסויים.

פרסונות  – למי שלא מכיר, היא מתודולוגיה מאד נפוצה בניהול מוצר. הרעיון מאחורי פרסונות הוא ״להמציא״ מספר דמויות המייצגות את קהל היעד שלכם, לאפיין אותן ולחשוב בכל שלב בתכנון המוצר איך אותם משתמשים פיקטיבים ישתמשו במוצר. לדוגמה: מייק הוא מעצב היפסטר בן 33 שגר בניו יורק, הוא גולש כמעט רק מהאייפון שלו, שומע פודקאסטים בנסיעה ב subway, בעל משכורת מוגבלת אבל אוהב להוציא כסף על מותגים איכותיים….

To read the full article, click here

By TLV Partners 16 Oct, 2017

For years VCs have preached to their companies the importance of tracking metrics that accurately measure their day to day operations.

Giving advice to others is much easier than implementing it yourself, and it takes guts to honestly measure yourself. When Eitan and I started TLV Partners, one of our earliest decisions was to track our key metrics. One of our top priorities in ensuring a professional experience for entrepreneurs, therefore we defined a set of metrics around our response time. More specifically, how many days it takes us to respond to emails (“respond”), set initial meetings (“set a meeting”), return with an answer whether we would like to proceed (“answer”) and conduct due diligence (“DD”).

Once we defined our metrics (we officially began tracking this data at the beginning of this calendar year), it was time to take a look at our performance. . We were pleasantly surprised to see the results, but there was clearly still room for improvement:

By TLV Partners 26 Jul, 2017
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But you can encourage your investors to collaborate by giving them veto rights as a group. Avoid giving veto rights to a single investor.  
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There is a common belief that participating preferred is always better for investors.

Here’s a brief overview of the various liquidation preferences investors may ask for. Liquidation preferences determine how to divide the proceeds from the exit.

  • Pro-rata distribution: Each shareholder receives their percentage in the company.  i.e. - shareholders that hold 20% receive $20M in an exit of $100M, 20%x$100M=$20M).

  • Non-participating preferred:  The investors receive their money back OR pro-rata distribution. Whichever yields more money to the investor.

  • 1x participating preferred: The investor get their money AND pro-rata distribution. This is often referred to as “double dipping”.

  • 2x+ participating preferred: The investor get 2x on their money AND pro-rata distribution.  In some cases, investors ask for a higher multiple - 3x-5x.

  • Interest: Investors often ask for annual interest of 4-8% on their investment.

VCs have one common goal - they all aim to increase shareholder's value. Many Israeli entrepreneurs share this dream as they want to build long-lasting companies. This alignment of interests makes sure everyone is working to achieve the same goal.

Yet, participating preferred creates an inherent misalignment of interest between VCs and entrepreneurs.

Take for example an entrepreneur who faces a decision whether to sell the company now for $150m. His investors agree that the company’s potential could be much higher in 2-3 years. But the company would have to raise another $20M to reach said potential. Luckily, there is a late stage investor who is eager to invest in the company at a reasonable valuation. The decision should be simple -  a good opportunity to increase the value at a reasonable price. But here is where the participating preferred misalignment kicks in. The entrepreneur, upon an exit, will have to pay back an extra $20m plus interest before seeing any profits. Not to mention the fact that he/she will be further diluted. VCs are professional investors and part of their job description is to take risks. Entrepreneurs are dreamers that dedicate their life to build companies. Some entrepreneurs at this point will decide to sell the company and reduce their personal risk. The investors will lose much more than the potential profit from the participating preferred.

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Cloud computing is an area we find especially exciting. It has brought enormous change to the world of applications and it would be no exaggeration to say that most of the innovation in IT over the past decade has been enabled, catalyzed, or caused by cloud computing. Currently, we are in the midst of a microservices revolution, one that has, until now, been championed by containers. Through our investment in Aqua Security over a year ago, we have witnessed first hand the rapid growth this market is experiencing, and believe it will continue to proliferate enterprises across the globe.  We are now on the cusp of another revolution in cloud infrastructure: the move to serverless computing.

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After a half-decade of quiet advancments in artificial intelligence (AI), 2016 was a turning point in AI. Computers are now smarter and learning faster than ever. The timing of this progress is no coincidence, rather it comes as a result of several coinciding market factors.

Take image recognition for example. Recent advancements in this field can be traced back to a team of University of Toronto researchers, who won the world’s top image-recognition competition in 2012. That team was eventually recruited by Google, and its approach, which relied on a technique called deep learning (a subset of AI), was quickly adopted by the company. In a short period of time image recognition systems based on deep learning have become much more accurate; test error rates are down to about 5%, roughly on par with a human’s performance.

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