How to Determine Equity Grant Sizes (it’s probably not what you think)

6a0134836082f8970c01bb08c1f798970d-200wiDetermining grant sizes or values is Part 4 and the next challenge in my ongoing series, “Stock Options on the Precipice”. At some point, you will arrive at a place where you will need to determine award sizes. There have been times where this was less difficult than it is right now. And, there will never be a time where this is as formulaic and consistent as base pay amounts.

The first question is whether grants should be based on a percentage of the company, a given number of shares or options or a dollar value converted into a grant amount. Much of this depends on where you are in the life cycle of the company. It is also driven by factors such as compensation philosophy, industry trends, potential timing and value for a future liquidity, public offering and more.

For very early stage companies, grants sizes especially for senior staff, are generally based on a percentage of the shares outstanding. When you have less than 20 employees and the value of the company is as much as a guess as it is a mathematical fantasy, percentages are often the only viable approach. But, this period ends very quickly. There are only 100 percentage points (despite leaders who demand that you give 110%). A grant of 1% is easy to understand but a grant of 0.00237% is unlikely to be understood or impress. The transition away from percentages usually starts no later than the tenth participant. Unfortunately, key hires for hot positions will often request grants in this manner long after it makes practical sense. Officers hired deep into your later funding rounds may also ask for awards expressed in percentages when values, growth trajectory and share levels no longer support this method.

The next move for many companies is simply picking a number of shares or options for different levels of staff. Often the number chosen is unadjusted for several years, regardless of what is happening to the stock price or the market. I sometimes refer to these companies as the flat earth society. This method can be a short-term fix in later-stage start-ups as they plow into their IPO. Unfortunately, that isn’t the case for most companies anymore. IPOs take longer than most companies expect and values at IPO are higher than ever. This was a standard approach during the dotcom period and companies drove right off the edge of their little planets. It has carried forward through three or four following phases of growth and collapse and should probably be put on the shelf as quick as possible.

The final approach often seems to be supported by survey data and accountants. Determine a dollar value and convert it to whatever type of equity you want to grant. This method seldom looks beyond the immediate timeframe. Please don’t spend too much time trying to convince me the accounting values used for compensation expense are true future projections of value. Without looking at the potential future value (referred to as “realizable value”) of awards, there is no way to know if current grant sizes are reasonable. Without detailed analysis of this sort, it is also impossible to know when things are going off-course (until it’s too late).

Lastly, grants must incorporate some understanding of potential value versus perceived value versus expected value. Since I am approaching the word limit for this article, I will save those concepts for a future post in this series (the next one will be March 15, 2016).

At this point in this series, I have touched on the possibility of a material change of direction in equity compensation (Employee Stock Options on the Precipice?). I have provided a quick method for performing an Equity Compensation Triage Assessment. I have also covered why the equity compensation survey data you are using is probably wrong.

I want to point out that all of these challenges do not make equity compensation a bad tool anymore than the challenges of becoming well-educated make that a poor goal. Equity compensation is an incredibly powerful, if sometimes fickle, component in building compensation and human capital value. The trick is navigating these often unfamiliar and always changing waters.

Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and has been deeply involved in equity compensation for a long, long time. Dan has written several industry respurces including, Performance-Based Equity Compensation and “Everything You Do in COMPENSATION IS COMMUNICATION”, with Comp Café writers, Ann Bares and Margaret O’Hanlon. He has co-authored “The Decision Makers Guide to Equity Compensation”and “Equity Alternatives” and a few books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.