How to Price Options?

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.

Rona