How to Measure Option Grants — Implied Value Method
Background
Determining the right size for an option grant when someone is hired is incredibly challenging. Factors that need to be considered are the employee’s job function, level of contribution, the assumed risk at the time they joined, and the shares available in the option pool. This is still challenging when considering a refresh grant later down the road.
Previous Methods
A typical approach is to find an appropriate range of ownership based on employment surveys or a set internal benchmark. We’ve looked at Option Impact’s survey data in order to make these decisions which gives us a percentile range based on ownership percent or value. Where this falls short is how different these ranges can be based on an employee’s tenure with the company, the company’s valuation, and the overall equity strategy. The expected ownership percentage is going to change over time with dilution, and it gets really hard to base the early grants in the more current reality. Awards end up feeling arbitrary and potentially biased.
Alternative Method — Implied Value
I don’t have a great name for this approach, but let’s call it the “Implied Value Method”. The foundation for this method is that:
- There is an “implied value” of an option grant at the time that it is delivered
- The implied value can be benchmarked against an expected percent of salary compensation
Implied Value — Here’s how you get there. The two pieces of data that you need are:
- FMV per share — In general I recommend using the most recent investor price. If it’s been a long time since your last financing round then I recommend adjusting that FMV per share by a reasonable growth rate (either tied to revenue growth or the change in your 409a value).
- 409a value — This will most likely be the exercise price for the option grant. Since a 409a value is calculated at least once a year (and definitely along with a round of financing), it should be relevant for the calculation.
The difference between these two values is the “Implied Value per Share”
Sizing the Grant — Now that you know the value per share, you just need to find out the total value (number of shares) to grant. The approach that I like is to set a percent of cash compensation that you think is appropriate. This can get complicated if you want it to, or you can keep it relatively simple. See below for an example:
Example 1: Senior Engineer hired in year 1
FMV (Investor Price per Share) = $2 per share
409a Value = $1 per share
Position = Senior Engineer
Salary = $140,000
Equity Value Needed = $70,000 ($140k X 50%)
Total Shares = 70,000 (Equity Value Needed/(FMV — 409a))
Example 2: Product Marketing Manager hired in year 2
FMV (Investor Price per Share) = $4 per share
409a Value = $2 per share
Position = Manager, Marketing
Salary = $140,000
Equity Value Needed = $56,000 ($140k X 40%)
Total Shares = 28,000 (Equity Value Needed/(FMV — 409a))
Let’s talk about what happened there. In the first year the company hired a Senior Engineer which needed a 50% value for the option grant (technical roles should probably be given a higher percentage for a technical product in order to provide more incentive to retain them). There’s an Implied Value of $1 per share, so the company should award 70,000 shares.
In the second example the company has grown and is more valuable (based on the investor price). They hire a Product Marketing Manager who needs an equity value of $56,000 (40% of their compensation). The implied value is now $2 per share, so the company should award 28,000 shares. This employee joined later and has taken less risk than the first employee, so the size of the option grant has decreased accordingly.
Promotions and Refreshes — This method can still be applied down the road. The value of the award is static. You always look back to what the Implied Value per Share was at the time of the grant, but when someone is promoted or there’s another justification for a refresh grant you can look at what their current expected value is and calculate the adjustment needed to get there. Let’s assume that another year has gone by. Employee 1 is still a senior engineer but has been with the company for 2 years, and Employee 2 was promoted from Manager to director. These are both reasonable milestones to use as a trigger for a refresh grant.
Example 1: Senior Engineer year 3
Years since hire = 2
FMV (Investor Price per Share) = $6 per share
409a Value = $3 per share
Position = Senior Engineer (no change)
Salary = $152,000 (cost of living adjusted, etc.)
Equity Value Needed = $76,000 ($150k X 50%)
Previous Equity Value = $70,000 (see calculation from hire date)
Total Refresh Shares = 2,000 ((Value Needed — Previous Value)/Implied Value per Share)
Example 2: Product Marketing Director year 3
Years since hire = 1
FMV (Investor Price per Share) = $6 per share
409a Value = $3 per share
Position = Marketing, Director (no change)
Salary = $160,000 (due to promotion)
Equity Value Needed = $80,000 ($160k X 50%)
Previous Equity Value = $56,000 (see calculation from hire date)
Total Refresh Shares = 8,000 ((Value Needed — Previous Value)/Implied Value per Share)
What you’ll see happening here is that Employee 1 received a small refresh grant based almost entirely on tenure with the company. Their original grant is pretty big because they were an early hire, which means that future grants will be lower in comparison. But, if you have a time based trigger for the refresh you can use that to find the appropriate equity component.
Employee 2 was promoted which increased their salary as well as their equity value band. I would recommend providing a refresh grant here even though it’s only been a year because there was a significant change in title. This really depends on when you want to issue refreshes.
How to Track — There’s going to be a bit of manual work to figure out the historical value. I was able to calculate them using a basic option grant report from Carta which I then built in a value schedule with associated dates. I wrote a formula containing a few different “if” functions so that the appropriate implied value was applied depending on the date of the option grant, and then I ran a pivot table to consolidate the information per employee (if Grant Date is less than “XX/XX/XXXX”, multiply by Cell XX, etc.).
Closing Thoughts
The system isn’t perfect, and none are, but you can customize these schedules as simple or complicated as you’d like. You can enter a wider range of levels, you can create different bands for every single department, etc. The advantage that I see is a risk adjusted and relatively objective method of determining grants. If you’re doing a lot of hiring then you can pre-calculate the grants in advance. For refresh and promotions you’ll need to put in a bit of work and play around with excel/google sheets. I also added a custom field in our HRIS system for the existing Equity Value based on these calculations. It’s something that I’ll update when they receive new grants, but then I’m able to run a report pretty easily.
If you’re hiring VP’s, this probably doesn’t work and you’ll need to use a % of ownership structure.