A Basic Guide to Options

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How do you know how much value you’re adding to a business and how do you know you’re being compensated sufficiently?

I found myself thinking about this recently.  It’s a difficult question to answer, it’s subtly complex.  I thought I’d write a little bit as, prior to a kind soul telling me how it worked, I didn’t have a clue.  I thought there might be others who maybe don’t know and don’t want to ask, so, here are some basic points and my musings regards value, equity, rewards and more…

If you’re a founder (or appointed CEO or founder lets say) then you deserve the rewards that come with that, decent equity (if you’re a founder / co-founder of course you own the entire business on day one and thus 100% of all share holdings).  If you’re an early stage employee or member of the management team (a director lets say) they I’d argue you probably deserve some equity in the business along with a salary although that might not be your market rate.  Nonetheless, you’re adding material value, taking a risk and so should be compensated.  I’d go so far to say any founder/CEO which doesn’t recognise this and does nor spread equity should be treated with caution as it’s an incredibly selfish strategy not to share the gains of success if a successful business is grown.  It’s worth knowing that even being given some equity does not make you an owner of the business.  The shares you’d be given as an employee are typically ‘C’ shares rather than A or B (founders, investors) but I’ll write a post on this subject.

I only really began to understand about equity, multiples, options, vesting etc in recent years,  The key thing to remember is that a tiny percentage matters (sorry if I am telling you how to suck eggs!).  If your business makes £3m net profit (EBIT) then it’s usually worth anywhere between x5 or x10 that amount (in some rare cases much, much more but we’re straying into valuation discussions).  So lets say x7.  Thats 3 x 7 = 21.  Thats £21m.  A 1% equity stake produces £210k upon a 100% sale taking place and assuming the business holds zero debt.  A 1.5% equity stake produces £315k.  So, a 0.5% difference equates to over £100k.  Thats huge.  Tiny numbers matter.

While I am on this subject, a founder may or may not take home a large amount pending how the business has developed but its worth remembering, a founder will (and should) always have more than employees as they’re the ones who had the idea, took the risks, got it off the ground etc… Hence my point earlier, a founder / CEO should be happy to share the wealth as those who are adding value will add more than enough to compensate giving some away.

If you’re an early employee with a lower than market salary you probably deserve some reward in the form of equity too.  If you’re adding masses of experience then you may well get some equity even joining at a later stage as you’ll still add material value.  Having said that, 9 times out of 10 a good competitive salary should be enough, experience will push this up over time.  One just needs to be sure that the salary / package is fair and this can be achieved by industry benchmarking.

Finally, some very well established businesses, some listed, also give some options to employees and typically they vest over 3 years upon which point they can be sold or hung on to, so long as you’re still with the company.

Taking equity can produce rewards, but not always, in the above example if the company value falls from the moment you secured options then they’re worth nothing really.   In larger companies / established companies Ltips can be used, thats Long Term Incentive Plans, typically for CEO’s, senior management and maybe board members which vest over time and are goal based.  They usually mature over 3 or 5 years and can be x multiple of a salary.  They’re used as an alternative to options and are typically found in listed companies.

So the question then becomes, am I adding value? if so, how much value and what is material value?  this is more difficult to answer.  Ultimately, the shareholders make the decision as to if and how much value one might one add.  The easy answer is when one has a direct influence over the profitability of the business (so senior management).  Yet this is rare as there are usually all sorts of variables in play.   This section requires a blog entry all of its own which I shall write!

Really, finally now (!), and maybe most important, equity is a nice to have.  It is a by product, not the end goal.   First and for most one MUST enjoy their job above all else.  Second you should get a competitive salary for performing well in that role.  Chasing experience is far more valuable then chasing equity.  Rewards will come one way or another if you’re with a successful business.,  Successful business only become successful because of the teams in place.

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