This is twelfth in a series of blogs on launching, growing and ultimately selling a technology company, with a corporate finance focus.  Topics include cap structures, equity plans, financing, corporate partnering, board matters and how to achieve a successful exit.

So you have determined you need a stock option plan for your company to incent your employees. To continue the analogy from my previous blog, you need to build a team of sled dogs to pull the sled, and you need to incent them with some tasty dog biscuits. So, where to start?  

Step 1: Set up a plan

A stock option plan, abbreviated as either SOP or ESOP (the latter meaning employee stock option or share ownership plan), is simply a plan to grant a certain number of stock options to employees over time.  These plans are sometimes misnamed, since stock options are typically granted not just to employees but also to senior officers, board members, advisory board members and even consultants. If you adopt a formal written plan (which you should), you should make sure it allows the Board wide discretion as to whom options can be granted. They are a useful company building tool, and make for happy sled dogs.

Step 2: Understand the math

Option plans are typically between 10% to 20% (and I have seen 30% or more) of the issued share capital of the company.  Option amounts are not factored into the “undiluted” share capital, but instead represent future dilution. It constitutes future dilution because options are simply the right to buy shares, not issued shares. The shares are only issued when the options are exercised — if they are never exercised they never become part of the company’s issued share capital. I see this mistake all the time in cap tables, creating confusion over who owns what percentage of the company.

Cap table calculations: Theory vs. practice

So, let’s look at an example. If a company has 8,200,000 shares issued and outstanding and its stock option plan is equal to 20% of that, it means there would be 1,640,000 stock options available for grant under the plan.

The number of stock options available under the plan do not form part of the 8,200,000 issued and outstanding shares. But if, and only if, all of the stock options are granted, and if, and only if, they are all ultimately exercised, would they be added to the total issued share number. The options constitute potential dilution and the total is referred to as the “fully-diluted” share capital. The fully-diluted share capital in this example is theoretically 9,840,000 shares.

However, companies rarely grant every option in their ESOP. So, more accurately, the fully-diluted number should be based on the actual number of stock options which have been granted (since it is unlikely that all 1,640,000 will have been granted at any given time). So, if the company has only granted 1,000,000 of the options available in the plan, the fully-diluted share capital is more accurately only 9,200,000 shares.

 TIP: Venture capitalists will argue that the higher number should be used as the company might grant the additional options at some point. They do this so that they can apply your pre-money valuation to your fully-diluted number to lower the per share price that they will pay for your shares.

Step 3: Choose the right percentage

For companies who are past the early start-up stage, I suggest using 15% to 18% as the working number for stock option plans. For raw start-ups, it is fair to start higher — even much higher — as they might need to add senior members to the team early and compensate them much closer to the percentages held by the founders.

For example, if the company starts with two founders, each of whom owns 40% of the issued shares, and they both recognize that they will need to add a key senior member to the team fairly quickly, they may need to provide that individual with a very large number of options to get them involved. Offering that individual an option for 4% to 6% of the company may not create the alignment you are looking for. As the company matures, the option plan should float down to the 10% to 12% range.

I get asked all the time about the right percentage to give to a particular employee, board member or advisory board member. The answer is “it depends”. It depends on the stage of the company’s development, how that individual is otherwise being compensated and several other factors as well. The number of options you grant employee number 5 is far different than the number you grant employee number 50 or 500, even though both may fill a similar role.  One size does not fit all and option plans must evolve in size and terms as the company does.

WORD FROM THE FRONT LINES

Finally, I like to see stock option plans have a “rolling number” of options rather than a fixed number. To use the example above, instead of fixing the number of options in the plan today at 1,640,000 options (15% of the issued and outstanding), I would instead fix it at 15% of the issued and outstanding share capital on a rolling basis. This means the number of options in absolute terms is always changing so that at any given time it equals 15% of the then issued and outstanding number of shares.

Continuing with our example, if the company does a financing and issues 1,800,000 shares next month (increasing its issued share capital to 10,000,000 shares), the number of options in the plan is automatically adjusted to 15% of that number — increasing from 1,640,000 to 2,000,000 options. This saves having to amend the plan from time to time, and awkward conversations with investors and board members about increasing the plan.

Next up, biscuits, biscuits, who gets the biscuits?

David practiced corporate finance law for 20 years representing numerous technology companies before retiring to co-found a venture capital fund where he was a partner and portfolio manager for ten years.  He now provides corporate finance/M&A advice to a portfolio of tech companies with a view to growing them to the point they are ready to exit and then leading that process.