A stock option gives the holder the right to acquire shares in a business at a specified price and time. The price is referred to as the exercise or strike price.
The purpose of the stock option is to reward employees, advisers and other team members by giving them the right to buy shares in the business sometime in the future at a price lower than its then fair market price. It should be noted that stock options are not shares they are simply the right to buy shares.
Stock Option Example
A business grants stock options to an employee to purchase 20,000 shares at a strike price of 0.05 per share. The strike price is based on the fair market value (FMV) of the shares at the date the options were granted to the employee.
After one year the business has done well and the fair market value of the shares increases to 1.50 per share. The employee exercises the stock option and buys the shares at 0.05. The increase in value to the employee is calculated as follows.
Share price = 1.50 Option price = 0.05 Increase in value = 1.50 - 0.05 = 1.45 per share Total increase in value = 20,000 x 1.45 = 29,000
* The gain made by the employee may be subject to taxation.
The employee now owns 20,000 shares in the business and will hopefully at sometime in the future sell these at an even higher value.
Vesting and Cliffs
It should be noted that the example is highly simplified and that in practice to avoid a new employee simply exercising all their options and leaving the business before they have completed their job, they would gain the right to exercise their options over a period of time.
In the above example the 20,000 options would still be granted to the employee but they might have to wait a year before they can exercise any options (known as a one-year cliff), and then might only gain the right to exercise them (known as vesting) at the rate of say 4,000 shares a year over the next 5 years.
If the employee leaves before the cliff they have no rights to exercise any options and will receive no shares, if they leave before any of the stock options vest they will forfeit the right to excise those options.
Stock options are particularly important for a startup using bootstrapping finance methods as they provide a mechanism to recruit, reward and retain key members of the team without using cash. In addition the stock options create loyalty and incentivize the team to perform to increase the value of their stock options and in doing so enhance the value of the business.
Effect of Stock Options on the Cap Table
Although stock options are not the same as shares, only the right to purchase shares, they can be included in the cap table to show the impact on the percentage shareholdings on the basis that all options are eventually exercised and converted into shares.
The cap table including the stock options is referred to as a fully diluted cap table as the effect of the stock option is to dilute the existing shareholders.
Fully Diluted Cap Table Stock Option Example
For example, suppose a business has the following existing shareholdings (these are the shareholding used in our earlier post on pre-investment cap tables.
| Holder | Shares | % |
|---|---|---|
| Founder 1 | 700,000 | 70.00 |
| Founder 2 | 250,000 | 25.00 |
| Team | 50,000 | 5.00 |
| Total | 1,000,000 | 100.00 |
The business now grants the 20,000 stock options referred to in the example above and the effect on the shareholding percentages is shown in the fully diluted cap table below.
| Holder | Shares | % |
|---|---|---|
| Founder 1 | 700,000 | 68.63 |
| Founder 2 | 250,000 | 24.51 |
| Team | 50,000 | 4.90 |
| Issued shares | 1,000,000 | 98.04 |
| Stock option | 20,000 | 1.96 |
| Total | 1,020,000 | 100.00 |
The effect of granting the stock option is to dilute the percentage shareholding of the existing shareholders.
Although the number of shares held by each existing shareholder has not changed, the total number of shares including the stock option is now 1,020,000 and therefore the percentage ownership of each shareholder reduces.
The existing shareholders who previously held 100.00% of the business are diluted and now hold only 98.04% as summarized in the table below.
| Holder | % Before | % After |
|---|---|---|
| Founder 1 | 70.00 | 68.63 |
| Founder 2 | 25.00 | 24.51 |
| Team | 5.00 | 4.90 |
| Shares issued | 100.00 | 98.04 |
| Stock option | 0.00 | 1.96 |
| Total | 100.00 | 100.00 |
Stock Option Pool
In the example above the stock option was granted to a specific employee. It is quite common in a startup business to recognize that as the business grows stock options will be needed in order to be able to recruit, incentivize and retain key personnel.
By assessing the number of key personnel the business will need in the future, it is possible to estimate the number of stock options that might be required and to express this as a percentage of the total number of shares in the fully diluted cap table. The stock options set aside from the unissued authorized capital is referred to as the stock option pool.
For instance suppose the business in the example above decides it needs a 5% stock option pool, it will calculate the number of shares it needs to reserve as follows.
Shares excluding options = 1,000,000 Stock option pool % = 5% Options required = Shares excluding options x % required / (1 - % required) Options required = 1,000,000 x 5% / (1 - 5%) = 52,632
Fully Diluted Cap Table Including Options Pool
The business now needs to have a stock option pool of 52,632 (including the 20,000 already issued) and the fully diluted cap table is as follows.
| Holder | Shares | % |
|---|---|---|
| Founder 1 | 700,000 | 66.50 |
| Founder 2 | 250,000 | 23.75 |
| Team | 50,000 | 4.75 |
| Issued shares | 1,000,000 | 95.00 |
| Stock option pool | 52,632 | 5.00 |
| Total | 1,052,632 | 100.00 |
Again the existing shareholders have been diluted by the creation of the stock option pool, for example Founder 1 before any stock options had 70.00% but is now diluted to 66.50%.
The effect on a shareholder can also be calculated using the equity dilution formula as follows.
% Before = 70.00% Stock option pool = 5% % After = % Before x (1 - Dilution %) Founder 1 % = 70.00% x (1 - 5%) = 66.50%
Where % before and % after are the respective shareholder ownership percentages before and after dilution.
What Happens if the Option Pool is Increased?
To avoid diluting the existing shareholders care must be taken not to increase the option pool beyond the amount reasonably required.
If for example the business decides it may need to recruit more key personnel in the future and creates a 20% stock option pool then the effect on Founder 1 is as follows.
% Before = 70.00% Stock option pool = 20% % After = % Before x (1 - Dilution %) Founder 1 % = 70.00% x (1 - 20%) = 56.00%
Founder 1 would be diluted from their original 70.00% down to 56.00% by the creation of such a large stock option pool.
Summary
It is important to understand the effect of the stock option pool on the fully diluted cap table. Each time the options pool is increased the existing shareholders are diluted.
At a later stage in the life of the business when it starts to raise equity finance, the investors will usually require that a stock option pool of 10-20% is created prior to their investment in order to ensure the business has sufficient options to be able to recruit, incentivize and retain the necessary key personnel.
The effect of the stock options pool on the pre-seed round cap table will be the subject of a later post.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.