Presenting Option Grants to Boards

One of the nearly routine items at startup board meetings is the discussion and ratification of option grants for new employees and possibly refresh grants for existing employees.  Too often unfortunately this information is presented to the board in a way that requires way more time than should be necessary because critical pieces are missing.

Here is what you should always include as a bare minimum when presenting option grants to the board

1. Employee name

2. Title/role at company

3. Absolute size of grant in number of underlying shares

4. Percentage size of grant fully diluted

5. Total size of option pool and remaining available pool (absolute numbers and percentages fully diluted)

Just #1 and #3 are not enough because it assumes that board members will immediately recall the number of shares outstanding which may or may not be the case and/or be able to quickly do the percentage calculations.

In addition here is additional information you should provide for context

6. Grant size bands by role (if you have established those already) — if not, include existing employees in similar roles for comparison (including their start dates)

7. Indicate if there are any special vesting considerations that differ from the plan

8. For refresh grants: how many options does the employee already have and how far are those vested?

Providing all of the above ahead of time (or even at the board meeting) will not only make the grant process quick an painless but also assures that you can actually get meaningful input from your board on the size of grants (as opposed to spending time digging for information and calculating percentages).

Options and Startup Common Equity Value (Bubble Talk)

There is something frequently missed in thinking about the value of common shares in startups.  These shares are actually options!

The Theory

A common share in a startup has the same payout structure as a call option.   There is a range of outcomes in terms of total enterprise value at exit for which common shares are worth exactly zero.   This range is from no enterprise value (shutdown) to the aggregate value of preference (including, if applicable, participation multiples and dividends) plus any debt that may be outstanding.   For enterprise values above that, the value of common shares rises more or less linearly (exactly linearly if you have only straight preferred).

This option nature of common shares explains why startups have a pre-money value at all even if they haven’t built anything.  That pre-money is *not* the value that has already been built.  If that were the case, then a prototype stage startup should have a pre-money of near zero (just try selling the prototype).  Instead, the pre-money valuation represents a view towards future possible values of the common shares.  A theoretically fair pre-money value would be one that looks at all possible future paths and discounts the price of common for various outcomes back to today.  Actual pre-money values are of course determined by the current market conditions.

Application: Is There A Bubble in Early Stage Valuations?

Now some folks have argued that the current significant rise in startup valuations is attributable to the fact that companies can achieve much higher exit valuations than before.  First, there are vastly more people on the web now than before.  Second, we have examples of hugely profitable Internet companies. Third, the time it might take for a company to grow to huge size has compressed.  With higher valuations possible faster that would indeed increase the option value of common today and thus explain higher pre-money valuations.

There is, however, an important offsetting argument.  Because the cost of getting started is now so low, there are many more companies being started to do more or less the same thing.  That significantly reduces the likelihood of any one company being the one that achieves these high value exits.   If your top-end valuation is 10x what it might have been in the past but there are 10x more startups being created to go after the same opportunity, then these two more or less offset each other (more or less is important here as this is non-linear and I am applying linear math).

I am pretty sure that what is going on right now is a largely unwarranted inflation in pre-money valuations because of survivor bias in the observable data.  It is easy to see the Youtubes and Zyngas.  No doubt the top end has moved out and speed to value has increased.  But nobody is really counting the huge explosion of startups that is launching, many of which will fail or pivot without really registering.