Giving options to employees - what's the exercise price?

Posted by Jennifer at 11:00 on 7 Nov 2017

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It's not immediately obvious why the exercise price is so important.

This is one of the questions that most often baffle founders when allocating options to employees, and also one of the most neglected questions. However, once the fundamentals of the concept are clear (and the relationship between the exercise price and value creation is understood), most founders find the answer is obvious.

So, let's work through the fundamentals...

What is the exercise price?

It's also called the strike price.

An option is an agreement, under which you can buy shares in the future at a fixed price. That fixed price is the exercise / strike price. You only pay this price when you exercise your right to buy the shares.

How does this work in practice?

Most options are not exercised until the underlying shares are about to be sold. So, if you have an option with an exercise price of £5 per share and you are about to sell the shares for £17 per share:

  • you pay the exercise price of £5
  • you receive £17 per share from the sale of the shares
  • you have a gain of £12 per share.

In practice, the payment of the exercise price and the sale are often handled as one process, so the more likely steps are:

  • the company writes to you, to tell you that it the company being sold to a third party, and you have the choice to exercise your option and sell your shares
  • you sign a form agreeing to exercise your options and sell the shares
  • you receive the difference between the exercise price and the sale price per share.

What's the link between value creation and the exercise price?

In the diagram below, the height of the shaded area under the graph shows the 'option gain' - meaning the net amount an optionholder would receive if they exercised their option and immediately sold their shares.

The diagram hopefully makes clear what an option fundamentally is: it's a right to the 'top slice' of value in a share. The size of that slice is determined by the exercise price and the share price at the time you're asking the question.

Another way of looking at it, is that an option is a right to value created from a given date. When the option in the diagram was awarded to the employee, the exercise price was set to be equal to the share price at that time. The option gain is the value created from that date.

You don't have to set the exercise price equal the share price on the date of award. If you set it at zero, then you're effectively giving the employee a right to value created from the foundation of the business.

So, the general rule is that:

an option reflects value created from a certain date. You set this by making the exercise price equal to the share price on that date.

What does the employee deserve? (The BIG QUESTION!)

Once we latch on to the idea that an option rewards value created from a certain date, we can start thinking about when an employee's contribution began and so what they deserve.

The question then becomes one of:

when did the employee start contributing to the value of the business?

The answers typically are:

from the date of founding of the business

from the date they joined

from the date they were promoted to a senior role

they haven't yet made a significant contribution, but you hope they will once they have an option (so therefore the date the option is awarded).

An example

Jane is the founder of TheBigShoeShop Limited, founded in January 2016. In October 2017, she is considering offering options to employees. Jane estimates the share price to have been zero on foundation, £5 in February 2017 and £11 in October 2017.

John has been advising the company since its foundation as a consultant, and joined as an employee in February 2017. Jane decides his contribution began when the company was founded, so gives him an option with an exercise price of zero.

Sarah joined as in June 2016. In February 2017, Sarah took on a new project which she excelled at. Jane considers that Sarah only started making a significant contribution in February, so she gives Sarah an option with an exercise price equal to the share price in February (£11).

Dave joined in August 2017. Sarah thinks Dave could contribute a lot, but hasn't done so yet. Jane gives him an option with an exercise price equal to today's share price (£11).

Where do you get the share price from in a private company?

You will probably need to discuss a current valuation with an employee incentives specialist. From this, you can determine a rule of thumb to estimate the value at points in the past.

Are there other considerations for setting the exercise price?

Yes - here are the two most significant ones:

  • if you set up an EMI plan (talk to a friendly employee incentive specialist about what this is), tax relief is only available on value created from the date on which the option was awarded. So if you award an option with an exercise price of zero, there won't be tax relief on value created between the founding of the business and the date the option was awarded.
  • if third parties have invested a significant amount. If you set the exercise price below the amount invested per share, employees are effectively getting a 'free ride' at the expense of those investors. If this is a concern, ensure the exercise price is at least equal to the amount investors have paid per share.

Is a simple share scheme right for your business? If so, have a look at emi-online.co.uk, a fast, simple and stress free way to give equity to your employees.

Please contact RM2 (020 8949 5522 / enquiries@rm2.co.uk) or consult our free fact sheet downloads for more information.