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While discussing the ATOM 60 stock options framework, we mentioned that when you think
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about how many stock options to grant to an individual employee, you must bear in mind
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that the financial benefit to that employee must be attractive.
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We also discussed that attractiveness can be quite subjective and usually depends on
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the earning capacity or annual worth of an individual.
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So a benefit of $200,000 in four years might seem attractive to someone earning $50,000
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a year, but may not seem so attractive to someone earning $100 million a year.
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So how do you decide what the intended benefit must be?
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Well, you look at it with respect to their criticality rating and their annual worth.
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Let us say you have an employee in a senior role that bears the highest criticality rating
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a drawing a salary of $75,000 per annum because they have taken a pay cut, but their market
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worth is $200,000 per annum.
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What would be an attractive intended benefit for such a role?
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Also, being a startup, let us consider a horizon of say four years, after which you expect this
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individual to earn that benefit.
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You would also waste those options over four years and you might assume a liquidity event
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of some sort, which means someone willing to buy your shares after about four years.
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So we have a senior role rated criticality A with a market worth of $200,000 per annum.
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What would be an attractive intended benefit for such a person after four years?
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While we will provide you with a few guidelines, I want you to think about this along with
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me.
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Let us start small.
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Would earning an extra $25,000 from stock options after four years be very attractive?
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Probably not.
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While some money is better than no money, it may not exactly classify as very attractive
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at a senior criticality.
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How about $200,000 in four years?
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Well that certainly sounds like a significant improvement over $25,000, but let us examine
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it further.
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$200,000 in four years means roughly $50,000 extra per year.
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But this person also took a pay cut, so they lost $125,000 per year in salary.
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While they earned only an extra $50,000 a year out of stock options.
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Now it does not look so attractive.
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Build your own personal scale to make these calculations.
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A good thumb rule to use is as follows.
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For someone at the highest criticality rating A, start with an intended benefit of about
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six to eight times their current market worth in four years.
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We always assume the intended gross benefit for an employee, just like we mostly talk
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about the gross salary and not the salary after tax.
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So in our example, using six to eight times the current worth of $200,000, the intended
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benefit comes to about $1.2 to $1.6 million in four years.
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Considering that they gave up a cash salary of around half a million dollars or more in
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four years, they would still profit from their stock options.
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If you go up to 10 or 12 times, the amount would be $2 to $2.4 million in four years.
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This was for criticality A. You could use the same or a descending multiple for criticality
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ratings B, C, D, and E. So if criticality A is eight X of the annual worth in a four-year
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period, B could be six X, C, four X, D, three X, and E, two X.
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Using a descending multiple essentially means you're using a weighted system where you
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assign higher weights to higher criticality ratings.
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If you were to use the same multiple throughout all the criticality ratings, people would
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still get a different number of stock options because their salary might be different.
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The difference in the grand numbers between two people under this method would be less
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stock.
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Using a higher multiple for higher criticality ratings might be reasonable to do in many
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instances where you believe that the ability to create value goes up with an increase
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in criticality.
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Try both the options, the same multiple for all, and a different multiple for different
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ratings.
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Think about it for some time and then decide what works best for you.
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So to recap, we start with calculating the intended benefit for an employee.
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An amount attractive enough for that individual at that criticality rating.
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But this amount will be earned by them through stock options and not as a cash bonus.
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You need to determine how many stock options you must give them so they can earn this intended
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benefit of $1.6 or $2 million in four years.
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They will earn this amount by selling the shares that they receive after exercising
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the options.
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So you need to understand how much profit one equity share might provide in four years.
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To do that, you need to look at your financial projections.
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