You should do these calculations in your journal yourself as we discuss them.
Morgan and Catherine decide that the right sales head needs to be in their 40s and would
probably be drawing around $200,000 per annum currently, but they can only afford to pay
$75,000 per annum.
So they need someone who resonates strongly enough with their non-financial vision to
consider that salary and top that up with an attractive stock option strategy.
They consider this role to be of the highest criticality rating, that is A, and agree
that an attractive intended benefit for such a person should be at least eight times their
current annual worth.
They realize that this amount is not a guarantee from their side, but will be realized only
if their business grows to a certain value.
Seeing the right person who resonates with their values and vision is key to achieving
that growth, and if they can find one, the financial benefit must also be attractive.
A benefit of eight times in four years means that the sales head should be able to make
$1.6 million after four years if things go as planned.
But what is that plan?
They need to drop their financial projections next.
They have only started up a few months ago and have a half-finished product with them.
They estimate their growth over four years and believe they would raise venture capital
during this period.
This would increase their number of shares, so they estimate the share capital to increase
to 40,000 shares, from the current 10,000 shares in four years.
They estimate that given the current market saturation in the education sector, it might
take them some time to make a dent with their uniqueness.
They estimate their company valuation at $40 million after four years.
$40 million divided by 40,000 shares leads to a share price of $1,000 per share after
four years.
Since the intended benefit to the sales head is $1.6 million, they would need to grant
1,600 options, assuming the options are granted at, say, 1 cent or almost zero exercise
price today.
So the arithmetic is done and now they have a number, 1,600 options.
But then they look carefully and realize that 1,600 options amount to 16% of their current
capital of 10,000 shares.
And this is just the sales head we are talking about.
They also need to grant stock options to a few other team members.
Something is not right.
So they start looking at each number more carefully this time.
First, the intended benefit.
They have considered it at eight times the current market worth of $200,000, which comes
to 1.6 million.
They could reduce that, but they realize that the intended benefit must be really attractive,
so for now they decide to keep it at 1.6 million and consider the other figures first.
Next, they notice they have considered the total number of shares in the fourth year at
40,000 shares.
They start analyzing that number and conclude they should be judicious by raising capital
from the investors and also raise it at a good valuation so they don't dilute much.
But that would mean delivering a really strong product with a healthy revenue.
That would come not just from adding more people to the team, but by strengthening the
core of the product.
So they make a mental note that if they wish to reduce their equity dilution but still
make the company valuable, they need to solidify the vision to attract the right people and
think deeply about the value proposition of the product.
They revise the total number of shares in the fourth year to 20,000 shares, from 40,000
shares.
Then they consider the valuation of 40 million dollars in the fourth year.
Now, this is not just about changing 40 million to something else so that the numbers fit
well.
It tells them something very important about their stock options strategy.
If they wish to give out 1.6 million as intended benefit, they have to get to a much higher
valuation.
The valuation of 40 million is certainly a good number, but at that valuation they may
not be able to justify an intended benefit of 1.6 million dollars.
So either the intended benefit needs to reduce or the value per share needs to go up.
As they still wish to preserve the intended benefit, they revise the fourth year valuation
to 1.60 million dollars.
But they now make a mental note that this would mean a certain amount of revenue to be brought
in.
And they need to ensure even more that their product is far better than what others have
an offer.
This does not mean more advertisements and more customer phone calls.
It means more contemplation on how that product could become valuable.
More physical labor, more resources without any additional intellectual labor may not
help much.
By contemplating deeply about their product, they can significantly increase its value
proposition, enhance valuation without spending a single extra dollar.
Reducing the fourth year shares to 20,000 and increasing the fourth year's valuation
to 160 million dollars brings down the number of options to be granted from 1600 to 200
options, which is 2% of their current capital and 1% of the capital in the fourth year.
Now if the eventual valuation were to get to a billion dollars, then the employee ends
up making much much more.
Similarly, if they were to reach only 40 million in valuation, those 200 options would
fetch much lesser.
So their strategy rewards the employee reasonably in case of a certain growth trajectory and
rewards them exponentially in case of an exponential growth.
Next they take up the other potential team members and rate them A, B or C depending upon
the criticality of their role and apply a descending multiple to compute their intended
benefit.
The process is the same.
Now they could further reduce the number of options by reducing the multiple or increasing
the valuation in the fourth year or decreasing the number of shares in the fourth year even
further.
But what you need to focus on here is the process.
Look at how the intended benefit can sometimes guide you to take decisions about your business.
As far as possible, try not reducing the intended benefit.
The key takeaway is let your vision and intellectual capital drive your stock option
strategy.
Use your non-financial vision to attract the right people.
Use deep thinking to infuse value into your product.
Valuation will take care of itself and your journey will be much more meaningful and enjoyable.