preparing for a company sale or IPO

Creative commons photo commercial use. Raging Bull by karanj on Flickr

For new companies that are short on revenues and capital and long on salaries and other operating expenses, stock options can be critical to long-term success. They give an added incentive for top talent to remain with the company in its difficult startup phase, particularly when the new company is trying to bootstrap operations as much as they can and keep compensation at a low ceiling. Executives may be willing to accept lower pay in return for the chance to cash out after a liquidity event like the sale of a company or an IPO.

• (Check out our Capitalization Table available for download)

But entrepreneurs face a conundrum early on as they begin divvying up stock options among themselves and their first employees: how much of the company do you give away? The need to keep costs down is pressing at the beginning. But if you do get as far as a liquidity event, those stock options you distributed to your staff and early investors may see a big boost in value – which is a good thing – but all of that value goes into others’ hands, not the entrepreneur with the vision to start the company in the first place.

How many stock options should your company distribute?

The first thing entrepreneurs need to consider is this: How many stock options should a company issue? Canadian companies typically keep aside between 10 and 20 per cent of the common stock; U.S. companies set aside more – 20 to 30 per cent. At an early stage, many companies offer stock options to most or all employees. But as the company grows, it is not easy to hand stock options to all or even most of its workers. Consequently, entrepreneurs need to use stock options as a privilege they offer only to some – maybe senior executives, instead of the rank and file. Decisions on this are usually based on the need to attract talent, the ability of the company to pay high salaries, and the tax impact of stock options. Besides employees, companies offer stock options to board members as well… (more…)