Buzz

Stock Options and Their Effect on Capital Structure (Part 1 of 2)

Alex Wilmerding, Boston Capital Ventures


Reprinted with permission from and originally published in Deal Terms, Aspatore Books, All Rights Reserved.

Competitive stock option programs are an integral part of a private or public organization's compensation policy. As such, stock option programs are a significant part of a company's capital structure and an important part of the valuation discussion and analysis that investors undergo.

As companies expand their headcount, their cash flow and, typically, capital needs increase for some period. Attendant with any increase in headcount presumably is the need to increase a company's option pool. The need for any increase in capital not only places dilutive pressure on a company's overall capital structure, but also erodes the percentage holding of employees who are members of a company's stock option program.

Balancing Financing Needs with Competitive Best Practices

The extent to which an option pool can be a significant source of discussion and consternation is directly tied to cost of equity capital for a company. Options are dilutive to investors. Whereas founders and angel investors often hold important positions in the capital structure of any early-stage company, a company's capital needs and the valuation tied to any equity investment assume significant needs in terms of options and compensation going forward. Few companies can run, scale, and generate handsome returns to investors without increasing their headcount and management team over time.

Companies that can point to compelling investment opportunities and command the interest of strong, established, and experienced equity investors should be able to agree to reasonable expectations on the part of prospective investors about the size of the future option pool and to what extent it will need to grow. The elements that any competent analysis of an option program need to have taken into account include defining the competitive market for compensation - specifically, the cash and equity components. Established accounting and law firms with a strong venture practice can be as strong a source of information as compensation consultants. Key to a company's success in both generating financing and remaining competitive is a strong commitment to reviewing current equity holdings of key management and assessing them in the context of the competitive marketplace. Investors will want to see a stock option grant strategy in place and are likely to make some quite definitive assumptions of their own regarding the size and growth of the option pool during the life of their investment in the company.

It is important to note that some investors - and strategic investors, in particular - may not realize market norms for option grants in small, high-risk companies. In many cases, their more conservative assumptions can pose a real challenge for management teams that are not compensated well enough, but realize that only after precedents have been set. Employees, too, have a lot to learn about stock option levels, but a board should assume that eventually employees will have to be closely aligned with the marketplace or, otherwise, should be prepared to compensate managers mostly in cash.

Employee expectations with regard to the number of options vary significantly. Interestingly enough, many employees are satisfied with a specific number of shares in a company without placing value on how that number of shares may translate in percentage terms. It may seem logical enough for an employee to assume, if the most recent price of preferred stock was $1, the employee is awarded 250,000 shares of options, and investors expect to sell the company for $4 per share, that his or her shares could be worth $1 million. What employees often lose sight of is the amount of capital a company may require, as conditions change, to meet its goals and how many additional shares may need to be issued. Whereas astute investors protect themselves from dilution through the use of preferred stock, employees are diluted as additional stock is issued, unless they are awarded additional options along the way.

Some employees focus instead on percentage ownership. There are obvious pitfalls to emphasizing or agreeing to employment contracts that tie options grants to a fixed percentage ownership in a company. This becomes a significant liability and a continued drag on the options pool as a company seeks to raise additional capital. But it is appropriate to consider awards set against some percentage benchmark for senior levels of management. I have seen wide ranges in ownership in many companies that are not yet profitable. The range for CEOs, some of whom own founders shares, can vary from 3 percent to 13 percent and for CFOs from 1 percent to 2.5 percent. I have seen the range for key executives, including vice president and director level staff, from .5 percent to 1.5 percent. Often geographic regions will have their own unique profiles, and so it is appropriate to ask experienced executive search professionals, attorneys, and accountants for a sense of the local market when it comes to options.

Dilution and the Protections Investors May Require

Investors are fully aware of the dilutive effect of a financing on an option pool. VC investors especially are typically keenly aware of market parameters and standards regarding stock option compensation. Strategic investors may not be as up to date as they are more familiar with options plans in much larger companies. It is not uncommon, therefore, that strict expectations for the size and profile of a stock option pool will be set at the time of a financing, enumerated and outlined in a section titled "Reserved Shares." Consider the passage below from a term sheet related to a financing:

Reserved Shares

The Company currently has or will have 3,000,000 shares of Common reserved for issuance to directors, officers, employees, and consultants upon the exercise of outstanding and future options (the "Reserved Shares").

The Reserved Shares will be issued from time to time to directors, officers, employees and consultants of the Company under such arrangements, contracts or plans as are recommended by management and approved by the Board, provided that without the unanimous consent of the directors elected solely by the Preferred, the vesting of any such shares (or options therefore) issued to any such person shall not be at a rate in excess of 25% per annum from the date of issuance. Unless subsequently agreed to the contrary by the investors, any issuance of shares in excess of the Reserved Shares will be a dilutive event requiring adjustment of the conversion price as provided above and will be subject to the investors' first offer right as described below. Holders of Reserved Shares will be required to execute stock restriction agreements with the Company providing for certain restrictions on transfer and for the Company's right of first refusal.

Right of First Offer for Purchase of New Securities So long as any of the Preferred is outstanding, if the Company proposes to offer any shares for the purpose of financing its business (other than Reserved Shares, shares issued in the acquisition of another company, or shares offered to the public pursuant to an underwritten public offering), the Company will first offer a portion of such shares to the holders of Preferred so as to enable them to maintain their percentage interest in the Company.

The purpose of the "Reserved Shares" clause in a term sheet is to set in place certain expectations that define exactly how large an option pool will grow before those preferred shareholders may benefit from any protection outlined in the clause. In the example above, the investors proposing the term sheet outlined that the financing would assume that up to 3,000,000 shares of common could be reserved "for issuance to directors, officers, employees, and consultants upon the exercise of outstanding and future options." The clause clearly places a ceiling on the number of shares of common that can be issued upon exercise of options by these constituencies. The clause goes on to detail that unless the investors agree otherwise, any issuance of shares as a result of additional options will need to result in full anti-dilution protection and an adjustment to the conversion price of the shares held by the investors who propose this round of financing. The clause clearly states, "Unless subsequently agreed to the contrary by the investors, any issuance of shares in excess of the Reserved Shares will be a dilutive event requiring adjustment of the conversion price as provided above and will be subject to the investors' first offer right as described below." The "Right of First Offer for Purchase of New Securities" language that follows the "Reserved Shares" clause in effect proposes that the investors proposing the financing be allowed to maintain their ownership percentage and in effect purchase more shares in the company if additional options issued result in the need to issue more than 3,000,000 shares of common stock.

The full range of an investor's potential tools in stock incentive planning includes the ability to require founders to bind some number of shares of common stock under a stock restriction agreement. In so doing, an existing ownership position can be treated as restricted stock that is earned over a period of years. This in effect resets the clock on the stock founders may own at the time of an early-stage financing. When market conditions and company progress indicate to investors that founders' option packages are either too rich or are in line with the market but owned outright, requiring that these individuals agree to extend the time frame they will need to work to fully own stock is one mechanism that can keep employees motivated, but not require a company to issue more options to do so.