For What It’s Worth: The Importance of Explaining the Value of Employee Equity
Employee equity is a popular incentive for ScaleUps, and for good reason. It helps companies take pressure off cash compensation, creates a culture of ownership and accountability, and often acts as a strong retention tool for employees.
In the U.S., while many employees understand the basic principles of equity, they often struggle to understand the potential worth of their options. In Europe, education around equity generally lags behind its U.S. counterparts (although we are seeing a shift here too). Regardless of geographic location, many ScaleUps struggle to effectively articulate what employee options can be worth someday – either overpromising or under-explaining. So, how can leaders better demonstrate the potential value of employee equity?
Explain how the price of employee stock option grants is determined
Options are first granted at a strike price (the price you will pay to exchange the option for a share of stock). The strike price is determined by the fair market value (FMV) of the share at the time the option grant was approved.
In the U.S., the FMV is determined by a 409A valuation specialist. Companies typically reassess their 409A valuation after equity financings and then at a regular cadence after that. In other countries, such as Germany, the strike price is based on the latest fundraising valuation. In other EU countries, you can offer grants at a reduced strike price (with country-specific restrictions) without any tax penalties. You do this by obtaining an FMV that is recognized by tax authorities. While tax-assured valuations might not be available everywhere, it is important to seek legal counsel to see what flexibility is possible. Even in countries where valuations may not be tax-assured, there are still precedents for offering reduced strike prices.
Estimate the potential value of employee options today
You can estimate this value by using the number of options in your equity grant, your strike price, and the most recent FMV / price per share. The potential value of these options will change as the company’s valuation changes – ideally increasing in value substantially.
Illustrate the value of employee options at a range of valuations
Instead of making broad claims (i.e., “we’re the next unicorn”), show what the value of options could be across a range of valuations. Early-stage companies, for example, are generally valued as a “multiple” of their revenue or ARR.
Employee equity is complicated. Taking the time to educate your employees around the value and other basic mechanics (e.g., vesting, exercising), is a must to truly make them feel like owners and ensure you aren’t overselling what their options can be worth one day. The worst-case scenario is promising a specific amount of dollars, which may or may not come to fruition. Instead, by clearly articulating how stock options work, you empower your employees and align them to your organization’s long-term success.