In Part 1, I discussed the benefits of offering stock options and how they help in attracting new talent, creating longer employee tenures, and providing the company with happier employees who respond with greater dedication and an increased work volume. If you agree with me and this sounds great, you need to think about a few things before you go out and adopt a plan.
Most importantly, you need to ask yourself if yours is the type of company where stock options make sense. This boils down to your exit strategy. If you are in business to only make money for yourself or your top people and you don’t care about going public or selling the company someday, then there is no need to waste your time with stock options. If you want to take care of your employees above and beyond their salaries and benefits you can always implement profit sharing, but you don’t need to offer stock options to make this happen. Having a stock option plan only makes sense if you plan to flip the company or go public. If this is your exit strategy, you can continue reading.
There are a number of ways to set up your stock option plan, and it is very important you do things the right way. The first thing you need to do is get a great attorney. I think I have the best one on the planet. His name is Randy Socol, and he is with DL Piper, one of the most respected firms in the country. They aren’t cheap, but if I have learned one thing, this isn’t something on which you cut corners. The main reason you want to make sure your options plan is set up correctly is because of future rounds of investment. A good attorney knows what venture capital firms like. He or she knows how to structure the plan in such a way that it will be “venture friendly,” giving you a greater chance of closing your funding.
The first thing you need to think about is how big you want your options pool to be. Typically, this consists of 8% to 20% of your total number of shares issued and outstanding. So for instance, if you have a million shares issued, your options pool would be around 80,000 to 200,000 options. Key employees and executives always get a higher amount than everyone else, so you need to make sure you have enough options to attract good talent. Stock options got a bad wrap in the early 2000s because of the dot com crash, but they have come back and in a big way. There are lots of companies going public or getting acquired these days.
Stock options work differently if you are going public than if you get acquired. Options are pretty straightforward if you are going public. As soon as you are public, those options are worth a certain dollar amount. This dollar amount will fluctuate as time goes on depending upon how the company performs. By the time you are able to sell your options, the price could be very different from when you first went public. Employee options cannot be sold when you first go public. It’s usually allowed in the first six to 12 months, but no earlier than six.
If you don’t plan to go public but you want to sell your company, those options are basically worthless until someone pays for them by buying your company. There are a number of ways to get your company acquired, including being bought for cash, stock, or a combination of both. If a public company buys yours, usually you will get paid in stock which has a real dollar value attached. This is what happened with the youtube guys. They received a lot of Google stock, which I would have taken any day of the week. Many times when you are purchased by a private company, the deal usually consists of more cash than stock, but it all depends. If the company purchasing yours is a lot bigger and plans to go public someday, then I would probably include a stock deal.
So what happens to all of those employee options when the company sells? It all depends upon how you set up your options pool, and that’s another reason why you need a great attorney. You can set up your pool whereby your employees’ options fully vest upon selling the company; however. this might not be a good thing for you. You want your employees to stick around, and if they are fully vested, it gives them an opportunity to look for another gig. You can set it up so that those options are purchased by the acquirer after the transaction goes through so your employees see an immediate cash payoff.
Either way, what you are trying to accomplish is to sell your company for a multiplier of your sales. So if you are making one million dollars a year, and you sell your company for five million, you just sold your company as a multiplier of five times revenues. If you have a million stock options that are worth $1.00 apiece, you now just made those shares worth $5.00 apiece. So if one of your employees has 20,000 options, they are walking away with $100,000 dollars in options. They need to spend $20,000 to buy those shares, but at that point it is well worth it.
Creating a solid stock option plan is important to not only attract the right talent, but to set up your company for a future acquisition, round of funding, or to go public. The only way to ensure that this is done right is with a great attorney, and great attorneys will cost you about $500 an hour. Your whole plan should probably end up costing about $4,000 to $8,000, but don’t skimp here. You will pay for it in the long run if you do.