Startups generally do not have large cash positions nor do they have substantial cash flows from operations, so they look for ways to pay sought after employees, managers, and executives with some type of equity compensation (at least partially) instead of cash compensation.
Employee stock options are often used as part of the compensation and to align the long-term interests of the grantees with the shareholders.
Since startups have no liquid market for their stock, it is not easy to value the grants of employee stock options. The value of the employee stock options depends on the current value or current market value of the stock. The options values also depend on the past and expected volatility of the stock, expected future dividends, expected time to expiration and the expected risk free interest rate.
All of the assumed values in the above paragraph have a substantial degree of uncertainty since their is little or no history of the price movement of the stock and therefore the current value of the employee stock options is not easy to determine.
The value of the employee stock options is quite speculative for startups. How many ESOs should “in demand employees” require to accept in the place of cash compensation? The answer is not easy.
Also, another concern for the employees with ESOs from startups has to do with how to manage the grants when the company becomes successful (perhaps the company has an Initial Public Offering). When do you exercise, and where do you get the money for the exercise price and to pay the taxes that become due when exercises are made?
If the stock has a ready market after the IPO, then there is no problem finding the cash to pay the taxes and paying the exercise price. Even then, the decision to exercise the ESOs may depend on a number of factors, because exercising when there is substantial time remaining to expiration forfeits part of the options back to the company and requires an early tax payment.
Keeping startups in mind, with consideration of grants of ESOs to employees, managers and executives, I have created a new form of employee stock options called Dynamic Employee Stock Options. This new type of ESOs (DESOs) benefits all parties to the options contacts and better carries out the goals that the grants of employee stock options are intended to achieve.
For a video of Dynamic ESOs, click here.