Stock Options in Tech Companies: What Are They Worth?
Identifying the key valuation questions for CFOs, key employees, and advisors that were granted stock options in private companies
Determining an exercise price for a new grant of stock options, understanding at which company value your stock options are at the money, or valuating stock options at fair market value for secondary deals or an immediate M&A event, these questions apply to CFOs and key employees who were granted stock options.
These questions are all closely related to companies’ current cap tables, and in most cases, companies’ cap table lifecycles can be summarized in 3 main steps:
From Creation to Seed stage: Cap tables are simple, including mostly common shares of founders with a few stock options that have been granted to key employees (i.e., the CTO, CMO, etc.). This is often done in order to motivate them and link their performance to the future success of the company.
From Seed to Series A round: Cap tables are still relatively simple at this stage. Founders raise additional capital from private investors, mostly through Simple Agreements for Future Equity (SAFE). SAFE’s primary benefit for private investors is to automatically convert their investment into equity at a next financing round. This round is defined in SAFE – with similar rights and a discount on the issue price paid by the new investor.
From Series A round to later stages: Cap tables are complex, and can include different classes of preferred shares and liquidation preferences, warrants, and pools of authorized stock options where a portion is granted at later financing rounds.
Let’s assume a startup raised $4 million through a Series A round, based on a $15 million post money valuation ($4 million/26.67%). In addition, the investor and the company granted an Employee Stock Ownership Plan (ESOP). The company’s 409A valuation analysis results in an exercise price of $0.5. The table below describes the post Series A cap table and liquidation preferences of the company:
Step 1: Suppose that the company is currently raising $5 million in a Series B round from new investors. The new cap table is created based on the following: $5 million divided by a 20% equity stake in the company on a fully-diluted basis, resulting in a post-money valuation of $25 million ($5 million/20%).
Step 2: A few months after the Series B round, the company’s management decides to grant additional stock options. The company 409A valuation analysis results in an exercise price of $0.58.
The table below describes the post Series B cap table and liquidation preferences of the company:
a.) Stock option holders received an exercise price of $0.5 and $0.58. At which company value will they be at the money, or in other words, at which company value will they start to earn money?
Let’s use AlgoValue’s Term Sheet Analyzer to answer this question. In this example, stock option holders of ESOP1 and ESOP2 with a strike price of $0.5 and $0.58 will be at the money, and will exercise their stock options only if the company value is at least $14 million and $14.88 million, respectively. If a willing buyer wants to purchase their stock options based on a lower company value, stock option holders will be out of the money (OTM) and will have no interest in exercising and selling their options.
Below is a table representing waterfall graphs generated from AlgoValue, illustrating the company value at which stock option holders start to be at the money:
b.) What then is the true amount of cash received by the stock option holders, if there will be a secondary deal or M&A event based on a company value of $50 million?
Below is the table representing an allocation of the company value and waterfall graphs generated from AlgoValue, illustrating the fair market value of these stock options:
So if there is a secondary deal or M&A event based on a $50 million company value, ESOP1 and ESOP2 stock option holders can sell their stock options at a fair market value of $2.085 and $2.005 per stock option, respectively.
Using a comprehensive analytical tool like AlgoValue’s Term Sheet Analyzer to understand the value of your stock options will give you a stronger basis for future negotiations on fair market value…or in other words on the amount of cash that you will receive!
Relying only on others to do this type of analysis and valuation may be a costly mistake. Expert advice should be utilized in these scenarios.
 IRC 409A valuation provides a common share fair value, which is the minimum exercise price for a new grant of stock options. In addition, most pre-Series A companies do not have auditors and do not need a signed 409A valuation report.