Ask the Wizard

I hesitate to even start writing about options. They make my head hurt. Anything I write about options will likely be met with the ninety-one different opinions about options that have been forged by ninety-one different prior outcomes for ninety-one different people. Options are like bad tequila, you wake up in the morning with packing tape where your eyes are supposed to be and all you can think is "It seemed like such a good idea at the time when that guy said 'hey everybody, let's issue options!'". I think I'll start the options discussion with some discussion of rudimentary starter points and only dive into the murky depths later on.

StarterTopic #1: The options pool
You have started your company and you're raising capital. You have been fortunate enough to get a term sheet that says these nice people will give you 2 million smackeroos for 40% of your company, thus giving you a post-money value of 5 million smackeroos. You previously owned 100% of the company, so now the investor owns 40 percent and you own 60, right? Well yes, but just for now.

Your investor is likely investing 2 million with the hope that you are going to put some of that capital to work by hiring employees to flesh out your organization, and savvy employees are going to want some form of equity. Far more often than not, your investor's terms are going to mandate that you create an options pool from which to issue these new employees equity. Who gets diluted to create this pool? Nobody and Everybody. Let's say your financing mandates the creation of a 10% options pool just so we can keep the math simple (you should assume you will be creating something between a 10 and 20 percent pool, usually more like 15 or 20). Let's say that your investor owns 400 shares of preferred and you now own 600 shares of common. The way the options pool gets created is that you will now authorize another 111 shares of common that will be unissued.

Why didn't you just authorize 100 options, since 100 is 10% of 1000? because those authorized shares are part of the total equity now and 100 is not 10% of 1100. Capiche?

Do you now own a lot less than 60% of the company? No, you still own 60% of the company because those 111 authorized shares for options are unissued. If you sold the company tomorrow, those 111 unissued shares dissolve into the mist and there are 1000 shares of which you own 600. Once you start hiring however, you will start issuing shares out of this options pool and as those options vest over the years, everybody dilutes. Pay attention because this is the really easy part of options and we haven't even done our first tequila shot yet. We are still having chips and salsa, and everybody is looking at the menu.

Starter Topic #2: Acceleration
When you issue options to employees, you generally issue them along with some vesting schedule. The vesting schedule says simply that you can't exercise the option to buy these shares on day one, you become vested in these options according to the length of your employent with the company. A typical vesting schedule is something like a 25% 1 year cliff with an additional 1/36th vesting every month for the following three years. In plain English, this means that if you issue employee A 1000 options, then none of those options vest until the 1 year mark, at which point 25% of them vest. Then, every month after that for the next three years, another 1/36th of the remaining options vest every month, such that at the end of four years, the employee is "fully vested"; ie, they can exercise their option on all 1000 shares and become the proud owner of 1000 shares of common stock in the company. I guess that wasn't plain English, but it will have to suffice.

Options agreements can vary wildly. Consult your physician thoroughly regarding all of this stuff. I mention it only as a prologue to acceleration.

The notion behind acceleration is that you may have employees who don't want to wait no stinking four years if something exciting happens to your company, like it is acquired or there is some change of control. There are different kinds of acceleration, but you will generally hear terms thrown around like "single trigger" and "double trigger". I'm really over-generalizing now, but single-trigger acceleration generally refers to a situation in which the options agreement states that all of the employee's options vest on a change of control, while double trigger may state something like "50% of unvested options vest on change of control and the other 50% vest on termination after change of control".

I won't go into my various opinions about acceleration here, largely because opinions about options are so frequently colored by what happened to you in the past or at the very least "what happened to me the last time I was issued options", and it's different for everybody, but suffice it to say that you want to nail down your company's approach to acceleration in the early going, have a definite philosophy and point of view about it given the different potential outcomes, and then try to maintain a consistent policy within specific groups of people as you grow the business and add more people. By "within specific groups of people" I mean that you might have one acceleration policy for external board members and another for employees, but try to have a consistent policy for employees and a consistent policy for BoD, etc. Acceleration is obviously dilutive to the existing shareholders but it's employee friendly, so you have to figure out what works for your company. Your investors will have strong opinions about this as well.

As with just about everything I write about here, there are 19 more things to say about acceleration, but this is a good start, and I really just want to lay the groundwork for an eventual discussion about issuing options vs. restricted stock.

My head already hurts, and we haven't even started talking about pricing, IRS 409A, and tax treatment of ISOs vs NQSOs.