You're hiring new employees and trying to figure out how many stock options to offer them. Or, you're thinking of joining a startup, and a component of your compensation will take the form of stock options.
How do you know what's fair?
It's one of the most frequent questions I get asked. Most people want to talk in terms of percentage ownership-0.1 percent, 0.25 percent, 1 percent- but that isn't the best approach. Every company is at a different stage and valued differently. Fair percentage ownership is going to look very different at a seed-stage startup valued at $10 million versus a Series D startup valued at $50 billion.
I've developed a simple methodology that normalizes these variables to come up with an Annual Cash Equivalent (ACE). The idea is to determine what the stock options would be worth if they were sold in the open market to an external investor. Once you know the cash value you can divide it by the number of years the stock options are vested over to determine the annual cash equivalent.
To determine the cash value of the stock options, use a stock option valuation calculator. There are plenty of good ones across the internet. Enter these five variables:
1. Stock Price
You'll need to ask for the stock's price per share during the last financing round, and then make your own determination as to whether it has appreciated in value since then. If the company is planning new financing in the near future, ask what the expected price per share will be--and then discount it a bit, because it hasn't happened yet.
If you're pretty certain that it's going to happen soon, discount it 10 percent. If it seems less certain, maybe use 20 percent.
Compare it to the previous financing round to assess the believability of that expected financing price. If the last round closed within the last six months, I would just use the last round price per share.
2. Exercise Price
The exercise price--also known as a strike price--is the price per share you would need to pay to buy the stock in the future. It will usually be at a significant discount to the stock price of the most recent financing, especially for early-stage companies. Typically, the more mature a company gets, the smaller the discount is.
3. Time to Maturity
This is the number of years before the option expires. It's often 10 years. For the purpose of this valuation, I would just use the vesting period--four years in most cases, but you should confirm with the company.
4. Annual Risk-Free Interest Rate
The interest rate has a very minimal impact on this calculation. Just use 2.5 percent.
5. Annualized Volatility
This has the biggest impact on the calculation. It's correlated to the stage of the company: A big, stable company with predictable cash flows like Walmart might have annual volatility of 20 percent, while a riskier company like Sears might be more like 75 percent or higher.
For a very early-stage company that has only done a seed round, I would use 125 percent. For a company that has done its Series A and has good momentum, use 100 percent. After Series B, use 80 percent. For later rounds when a company is doing well, 60 percent.
You might need to interpolate depending on the risk and the stage. Just keep in mind that the volatility is a proxy for risk, which is correlated with upside. You can always use two different volatilities to give yourself a range of values.
Once you get the price of the option from your calculator, multiply it by the number of stock options you are being offered. Your number is the total cash market value of your potential options. If they vest over four years (most do), then divide this value by four to get the annual cash value equivalent.
Don't be tempted by what the stock could be worth. Note that this methodology doesn't consider ownership percentage--that's irrelevant if you know the true market value of the options.
I've had success using this methodology in the past. It's very helpful in keeping compensation consistent, especially because new employees always join throughout very different stages of a company's life. You should, of course, do your due diligence and bounce things off an experienced accountant.