How to set Option Exercise Price?
I just incorporated a Delaware C Corp a few months ago and have no significant activity yet.
I have 2 Advisors that I need to issue options to, and my question is how do I set the option exercise price? I've found a very good white paper here: http://www.google.com/url?sa=t&source=web&cd=1&ved=0CBUQFjAA&url=http%3A%2F%2Fwww-bcf.usc.edu%2F~kjmurphy%2FHallMurf6.pdf&ei=IHCFTPLUOIK6sAOC0Mn2Bw&usg=AFQjCNG8YQwUJdPP4QIbQ8FBsjDQW9DFRw&sig2=_jE-0g8snG0vhkjrFsw08A The paper suggests to set the option exercise price at-the-money, i.e. at the price of the share on the grant date.
Based on your different experiences, do you have any comments on suggestions on this? I'd like a perspective on tax issues too if possible.
Thanks!
3 Answers
Typically, your option price is 8-15 x LESS than your common share price but that's all pure rule of thumb.
A great article that details how to set Employee Stock Options is here. It goes a pretty good job of explaining how the government wants you to calculate it.
Traditionally, options have been set at 1/10 the round price since the math was easy and no one really paid attention to options. Nowadays, the option price is looked at since it's supposed to be adjusted when the risk of the venture is reduced. So, the closer you are to a product or exit, the closer the option price should be to the stock price (within reason).
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Jarie, the article you mention talks about the value of the option. He's asking about the exercise price. Also, the 1/10 rule of thumb was compared to preferred. Here he's talking relative to common stock. – Dror 14 years ago
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Dror, The exercise price of the option is that the value is set at the time of grant. The option price may change over time but when you get granted options, that's the exercise price of that option. You can also apply that ratio to common as well if you don't have preferred stock in the company. In the end, your answer related to the reasonable valuation are the factors that ultimately determine what the venture is worth. – Jarie Bolander 14 years ago
In your scenario, yes, the option price should probably be set to the price per share at the grant date. In other words, your company today is worth the same as it did a few months ago when you incorporated it since, as you mention, not much has happened since.
Here's a lawyer's discussion of this:
http://www.startupcompanylawyer.com/2009/01/01/how-do-you-set-the-exercise-price-of-stock-options-to-avoid-section-409a-issues/
What are the acceptable methods for determining fair market value of private company stock?
The fair market value of private company stock must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company.
The factors to be considered under a reasonable valuation method include, as applicable:
- the value of tangible and intangible assets;
- the present value of future cash-flows;
- the readily determinable market value of similar entities engaged in a substantially similar business; and
- other relevant factors such as control premiums or discounts for lack of marketability.
You should probably talk to a cpa/accountant/attorney about this as it has significant tax and other implications.
Setting the price "At the money" sounds reasonable.
