HBS OPTION COMPENSATION WORKSHOP Professor Brian J. Hall February, 2001 © Brian J. Hall

What is an Option? Contract between a company and an employee giving the employee the right to purchase shares of company stock at a certain price by a certain date -Term or maturity -Vesting -Strike or Exercise Price -ISO/Non-Qualified -Valuation -Pre IPO vs. Options in publicly traded companies

Why Options? Ownership incentives Accounting Treatment Retention Preserve cash (in start-ups) Rationale : Options are not going away any time soon.

Options v. Stock Value Stock Value $.50 $1.50 Current Stock Price Exercise Price “Strike Price” Option Payoff if you sell today

Underwater Options Value $.50 $1.50 Strike Price Current Stock Price $.30

Nuts and Bolts –Term: How long until you must exercise -Standard: 5-10 years Vesting: When you may exercise ( e.g. when you actually “own” the options) –Forfeit unvested options if you leave. –Standard: 2-4 years (e.g. 33% per year for 3 years) –Sometimes there is a cliff at 1 year, then monthly thereafter. Employees may not sell options. They can only exercise early.

Taxes Non-qualified options (most common): Taxed as ordinary income at time of exercise -Modest tax benefit from deferring taxation Incentive stock options (ISOs): Taxed at capital gains rate at time of stock sale. (i.e. not at exercise unless you also sell the stock) -Huge tax advantage

Valuation ( Publicly traded companies) Standard option pricing formulas (such as Black-Scholes) are not correct because: -Options are not tradeable -Employees are undiversified and risk- averse BS generally overstates the value of an option to an employee or executive because: 1. Employees may leave early, forfeiting unvested options. 2. Employees may exercise early, shortening the term. 3. Employees are not perfectly diversified.

Option Valuation But BS is a good place to start, before making adjustments. Option value is a function of: -Stock price -Exercise price -Volatility -Dividend rate -Risk-free rate Use the spreadsheet

Multi-Year Plans Most option plans are multi-year and this creates confusion. -New grant each year -Each year’s option grants vest over time.

Steps to Valuing Options (publicly traded) Goal: To determine a cash equivalent. Step 1: Determine BS option values under various times of departure. Shorter durations lower BS values directly Shorter durations often lead to forfeiture of unvested options

Step 2: Adjust resulting values down because of risk aversion and non- diversification. 10% discount if risk tolerant 30% is median 50% if very risk-averse Step 3: Adjust for taxes.

Potential confusion: Multi-year options combined with multi-year vesting for each option package. Example: 5 year options Vest over 4 years ( 25% per year) Stay indefinitely versus leave after 3 years

Stay indefinitely Option Grant at: V VVV V VVV V VVV

Leave after 3 years Option Grant at: V VVV year options, lose 1/4 2 year options, lose 1/2 1 year options, lose 3/4 V VVV V VVV

Options in Start-ups It is a bit misleading (though not incorrect) to call options in startups options. These options have such low exercise prices that they are often much closer to stock than what we normally think of as options. They are also riskier and illiquid. Very hard to value--like valuing Pre- IPO equity.

Options in Start-ups: A Quick Journey Value: $4 million Pre-Money Number of Shares: 10 million shares Founder Strike Price: $.00025

First Investment: $1 million Calculating the percentage of Shares Sold to Early Investors Investment Investment + Pre-Money $ 1 million $1 million + $ 4 million = 20% -Calculating # Shares Issued to Investors 10 million shares $ 4 million Series A Shares $ 1 million = = 2.5 million Series A shares = $.40 per share ($1 million/2.5 million shares

-Calculating # Shares Issued to Investors 10 million shares $ 4 million Series A Shares $ 1 million = = 2.5 million Series A shares = $.40 per share ($1 million/2.5 million shares)

Ownership before & after Investment

Creating the Option Pool Create a pool of 2.5 million options. Exercise price is 10% of Series A (preferred) strike price, which equals $.04. –(Series A strike price is $.40)

New Ownership Percentages

Second Investment Value: $10 million Pre-Money Investment: $6 million Share of 6 million = 37.5% Ownership 10MM + 6MM Calculating # Shares Issued to Investors 15 million shares= Series B Shares $10 million $6 million = 9 million shares at $.67 per share

New Ownership

When Valuing Pre-IPO Options Think %, not # of options. Value at last round of financing Value at next round of financing How many more rounds? How much more dilution? Current strike price ISO/non-qualified Benchmarks: J-Robert-Scott.com --See their comp survey.

Some Rough Equity Benchmarks Executive Title% of Stock Owned CEO11.2 VP Sales1.9 CTO6.9 VP Business Dev’t3.6 VP Marketing2.9 VP Engineering2.9 VP Operations2.3 VP Finance1.5 Director Level Hire: Early Rounds of Funding: 0.5 to 1 percent Later Rounds of Funding: 0.1 to 0.5 percent

Negotiating your compensation offer Be systematic and thorough in analyzing what you want Don’t be narrow: you almost certainly have a very broad set of interests. Think about tangible and intangibles. Think about how you would trade off the tangible and intangibles-you probably will need to make such tradeoffs.

Be wary of your own biases. Many, but not all, people will have: -A bias toward the measurable. First year salary is measurable. -A bias toward the short-term

Consider your own BATNA Don’t ask: “Do I like this offer?” Rather: “How does this offer compare to realistic opportunities?”

Don’t manage the search to get early offers that may explode Attempt, if possible, to get offers in a short window so they can be compared. Exploding offers - Politely ask for more time -Politely request other companies to give you a faster decision (or “read”)

Learning to live comfortably with uncertainty-exploring (and perhaps sitting with several options) simultaneously while avoiding fixation on one job or one characteristic of one job-can be painful (“stressful-just want to get it over with”) but very helpful.

How much do you care about?: “the building of a career” “More human capital building: HBS II” Negotiating your career

Be prepared for sticky questions. Question: “Would you take the job if we offered one to you?” Answer: “Would you agree to make me an offer if I agreed to accept it?” --if you don’t want the job.

Answer if you might want the job: Reframe the question--”Do you really like the company?” “Well, of course, like all decisions, I would want to take some time to make a well-thought-through decision, but I am extremely excited about the company….What I am most excited about is X, Y, and Z.”