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