How should a prospective employee value stock options when considering an offer?

Stock options can be a very valuable part of the employee's total compensation and communicating this to staff is crucial to maximize this employee benefit. When an employee is granted a stock option the first is to illustrate what type of an award this is. An option has an exercise price that typically is the value of the common stock on the date of the grant. This means that the employee must pay that price upon exercise of the option. However, the real value is in anticipated appreciation of the company stock over time and thus, the award becomes valuable and in some instances, extremely valuable. There are several methods used by companies to value stock options (Black-Scholes being the most popular) however, this is only a theoretical value and may or may not be indicative of the future value of the underlying shares. In my opinion, the employee should look to other factors when considering the value of the stock option such as historical growth of the company, what are the exit potentials (IPO, acquisition) and most importantly, can they add to this value by their contribution as a member of the team.

Depending on the company and the offer, it may be a retention tool, replacement of current unvested equity the applicant may be leaving on the table, or may be in lieu of cash (especially in cash strapped/ start-up scenarios), you want to conduct due diligence on the stock performance, competitors, business strategy and calculate annualized NPV of the award (this will allow you to factor in the purchase price of the option, tax treatment, and possibly the exercise methods afforded to the optionee in the plan).

When considering stock options in the compensation mix, they should be valued at the level they are worth today. It is very dangerous to perceive a future value. It is quite common to offer equity options to entice talent for an early stage start-up. Some times the approach pays off and sometimes it does not. Options are clearly a benefit, and maybe a component of long-term compensation, at some undetermined future date. But it is very dangerous to accept options in lieu of cash.

If the company is public, you should look at the company's historical price performance, business prospects, etc. and make a judgment from there. Some companies are steady, others are volatile, and some are hard to judge. All things considered, it's a wild card, so I agree with the focus on cash compensation with stock options being upside.

For private companies, and assuming you're in a position to ask these questions, I'd want to know the valuation on the last round of financing and the what your grant represents as a percentage of the total outstanding plus granted. Some companies offer big grants but their outstanding is a huge number, so translating your grant to "what needs to happen for me to see real appreciation" can be a challenge. I was once offered a huge number of shares, then learned that the outstanding was in the billions of shares, so the number meant little.

10,000 options equaling a tenth of a percent is a very different calculus than 10,000 options equaling one-one hundreth of a percent of the post-money valuation of the last round.

It takes a lot of diligence to determine the value of an option in a pre-employment situation. I would say it might even be impossible. Without repeating anything already said, another tricky part of options for employees is the potential dilution that might occur due to a "transaction" for the company. Depending on how the financing is worded for the venture rounds (if that is how it is funded), the common shareholders may have even less ownership than what you anticipate. My advice is to appreciate the offer of an option but do not place much value on it in the beginning.

In any job that pays a salary, the upside potential of the options should be seen as simply a bonus or marginal incentive. For those situations where the option is the only form of compensation, there is a need to make assumptions of the future potential value and liquidity of the option against the expected number of hours worked at the hourly rate. While Black Scholes valuation formulae may produce a theoretical value of a grant for GAAP purposes, I don't believe many companies accept the BS value as being a meaningful value for compensation purposes, at least in start up situations.

From the employee perspective there is an attraction in receiving future compensation potential in a deferred tax manner compared to fully-paid stock. But if an employee or consultant has to exercise an option (and pay the cash and go "on-risk") upon termination of service, the value of the option would be significantly less.

If you are paying someone only options for services provided, make sure that there is no exposure to being classified as an employee as this may open up minimum wage issues in some states, and make sure that the individual is made fully aware of the risks of his compensation being of little or no value or liquidity.

There are numerous online articles that you can search about this and you may even find some spreadsheets to value ESOs, though they do depend on more parameters and assumptions than using the simpler (and inaccurate for this purpose) Black-Scholes model. Off the top of my head, my recollection for a rule of thumb from one of the better articles is that ESO values fall in the range of 40-60% of the B-S value. Some of the reasons for this lower value are the lack of marketability and vesting restrictions. Using another rule of thumb that B-S values are roughly 1/3 of the stock price, that translates to 13%-20% of the stock price. The usual long list of caveats and assumptions apply. :)

If it's a public company, you can see how the company values their ESOs from their 123R footnote disclosure but beware that if they use B-S, it's over-valued.

As some of the other commentators allude, at the end of the day, you can't count this as money in the bank because it's still a coin toss whether the company and its stock price succeeds or not. In the unlikely situation (for an Assistant Treasurer) that you can negotiate the magnitude of your future stock compensation and if you are more risk averse, you may try to request a greater component of restricted stock units rather than riskier options.

If you need further help, please get in touch.

Speaking solely about privately held companies:

Stock and/or options aren't worth the paper they are written on for several reasons:

1. What are the odds that the company will go public?
2. What are the odds that the company will be sold?
3. So now you are an owner, what effect can you have on the company (being a terribly minor owner)?
4. You want to sell the shares, to whom?

The list goes on... So I agree with Regis, options may be a better bet, but based on the odds, its not a great bet.

Just a thought...would the labor laws no longer apply to "owners" (be their position be so ever small)? Could a base salary be given to production employees with a gain-share type bonus program once everyone owns a little stock? Obviously today all direct labor to be paid hourly with overtime pay. We all know overtime is a natural inducement to underachieve...could this legally be a method to engage and motivate within a privately held company? Then to even treat a portion as a retirement fund? Just thinking out loud here? Obviously, I never want to violate any laws; however, could this be a way to engage direct labor while providing above average remuneration?

If it is a privately held company, I would place no value on them whatsoever as part of an initial employment offer. In fact, they could end up costing you in the long run. My advice would be to angle your negotiations for cash or bonus in lieu of options.

I look at it as the upside but would assign little, if any, value when making a decision on employment. It maybe something that you want as part of your deal, but I would not assume any financial benefit.

Good question. The best thing to do is to ask the prospective employer what the last round of financing were, when/what price the last option grant was and maybe most importantly, whether a recent 409A valuation was completed by an outside valuation expert. Companies like mine (Frank, Rimerman + Co) perform valuations like these all the time for private companies to use for stock option compensation purposes so that valuation report would provide a wealth of information about the prospective company, if the employer is willing to share it with you.

If the question was more concerned with how much value you should place on getting stock options as a part of your compensation package, I would consider it to be potential upside to you in the long-term, but little actual value to you in the near-term. Your salary and bonus consideration are much more important and likely to provide actual cash to you as opposed to stock options that may or may not appreciate in value over time.

I'd be happy to walk you through some more specifics of valuing options if you'd like to contact me directly. Good luck!

they should be the gravy, not the meat. Obtain the base pay and bonus you need and stock is a plus.

For stock options to receive favorable tax treatment, companies are required to grant stock options at fair market value. Assuming for a moment that a private company has hired a qualified appraiser to perform a valuation of the stock (an independent appraisal by a qualified appraiser gives the company a safe harbor with the IRS under 409A), I would suggest that the future employee place reliance on this per share value since they won't be able to come up with a better reasoned value. If the future employee places a priority on the size of the option grant, it would be useful to understand what % their grants makes up of the total outstanding shares and whether this is a reasonable %. Radford compensation survey, if you have access to it, is one source that gives option grant % by position.

I agree that stock options should generally be valued as upside verses setting any expectations. That said, the following should be considered in attempting to access the upside: 1) what's the number of shares outstanding on a fully diluted basis, 2) what is the potential future value of the company, 3) what is your strike price, and 4) what is the vesting period. Venture funded start-ups may give 3%-5% of fully diluted shares as option grants (with vesting) to CEOs and 1% to VPs. Directors may be about 10% to 20% of what VPs get. The value of the company can often be estimated as a multiple of future revenues (just divide the value of the company less obligations/preferred preferences by the fully diluted outstanding shares and you have an estimate of your upside...after subtracting your strike price). Of course, there are many potential complications making any valuation more of a guestimate.

A survey done by Culpeper (a benefits consulting firm) found that 87% if companies use Black Scholes for valuing stock options for financial reporting purposes. You can obtain for free on the Internet a Black Scholes model, although some are inaccurate. The key discretionary inputs are the volatility of the underlying stock, the value of the underlying stock (if it is nonpublic), and the expected (rather than contractual) life of the options. After all of this you should find that the value of an at-the-money option is +/- 30% of the value of the underlying stock. Even most valuation analysts tend to overvalue options because of inexperience in valuing this specialized instrument and failure to make appropriate estimates of volatility and expected option life.