Chris Dixon

  • May 13, 2011
Options

The financial term “derivative“ refers to a security whose value is a function of another security such as a stock or bond.  The most common types of derivatives are futures – the obligation to buy a security at a future date at pre-agreed upon price – and options – the right to buy something at a future date at pre-agreed upon price.

In theory, the primary societal purpose of derivates is for businesses to hedge against “exogenous” risks.  For example. Southwest Airlines is famously prudent about buying futures on oil to mitigate the effect of fluctuating oil prices on their core business.

In practice, most derivatives are bought and sold by speculators. One of the first speculators was a philosopher names Thales, who Aristotle described in his book Politics (Book 1, Part XI):

There is the anecdote of Thales the Milesian and his financial device, which involves a principle of universal application, but is attributed to him on account of his reputation for wisdom. He was reproached for his poverty, which was supposed to show that philosophy was of no use. According to the story, he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive-presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest-time came, and many were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort.

Valuing options was a mystery until 1973 when the Black-Scholes model was invented. The main practical outcome of this model was the idea that the value of an option was determined mostly by the volatility of the underlying security.

One way to understand the important of volatility is to think of options as the opposite of insurance policies. Suppose you are selling insurance on houses in one region that is prone to catastropic events and another that isn’t. Rational insurers would price insurance policies higher in the catastrophe-prone areas.

Startups are inherently very volatile – their price can increase or decrease dramatically in short periods of time. Having an option on a startup is the economic opposite of selling insurance in a catastrophe-prone area.

The US tax system has some rules related to startup options.  The first rule is that there is a special class of options called ISO options that can be granted to employees. ISO options are tax exempt until the options are exercised, which allows employees to receive them and not be liable for taxes until they actually realize cash gains. This rule only applies if the options are assigned a strike price equal to or greater than the “fair market value” of the company’s common shares. The fair market value is normally assessed by an outside valuation firm (a so-called 409A valuation) and usually ends up being significantly lower than the last round VC valuation (a rule of thumb for early-stage companies is the strike price will be approximately 20% of the last VC valuation).

When you are granted options in a startup there are a couple of important things to keep in mind:

1) You should know your percentage ownership of the company’s “fully diluted” outstanding shares (number of shares of the company including the option pool).

2) You should understand that if you leave the company, you normally have 90 days to “exercise” the options (purchase the shares you have the right to buy) before you forfeit your options. Normally the company has no obligation to inform you of this possible forfeiture, and in fact the standard practice is to hope the employee forgets and loses the options.

3) You should know the “preferences” on the company.  The preferences normally equals the amount of money raised. If the company sells for near or less than that number the common shareholders, and hence the employees (who own options on common shares), will receive little or no money.

The strike price of the options is somewhat important but, if you study options theory, not nearly as important as the volatility of the underlying stock. Financially, what matters most is having a reasonable percentage of options in a company with lots of volatility (and hopefully a stock price that has an upward slope).

 

  • http://steamcatapult.com/ Dave Pinsen

    Good post. If memory of my college philosophy classes serves, Thales wasn’t the only philosopher who made money in the olive oil trade.

    Coincidentally, this guest post of mine on Tim Knight’s blog Thursday night includes a discussion of the distinction between using options to speculate and to hedge.

    BTW, saw a royalty-free download of Portfolio Armor yesterday — was that you using the promo code successfully?

  • http://profiles.google.com/zynest 翊 张

    Dear Sir,I am a social enterprise Entrepreneurs (E-commerce) come from China, Current, In addition to introduction of several partners on the Website, There are a number of Beijing College Students willing to join. I hope you can pay more attention – http://www.aladdinsring.com
    Sincerely, Zhangyi

  • http://blog.redfin.com GlennKelman

    Good post Chris, but just about every company warns employees about the 90-day window to exercise the option; in part because you want departing employees to have a stake in the company’s future success. What many option-rich and cash-poor folks don’t realize is how expensive it is to quit, because of the exercise price. 

    • http://www.cdixon.org chris dixon

      I hope that’s the case (but not what I’ve observed in my limited experience). Obviously the ethical thing to do is to let the employee know. 

  • http://www.lhartwich.com Lukas Hartwich

    “…a rule of thumb for early-stage companies is the strike price will 20% of the last VC valuation”, interesting I didn’t know that what amounts to “back-dating” for public companies is common practice in the startup world.  Perhaps it’s a way of compensating for lower salaries?  Any ideas?

    • Anonymous

      My understanding is that there are a few things going on.  First, the VC valuation is based on a purchase of Preferred Stock (“PS”), not Common Stock (“CS”).  PS is like a combination of debt and equity and possesses certain rights preferential to the CS (hence the name).  So, even if the PS converts to CS on a 1:1 basis, it’s still arguably more valuable than the CS.  Second, the price a company is valued at by VCs is really just an indication of how much investors are willing to pay for the PS — which doesn’t tell the whole story about the value of the CS (or the company as a whole). 

      In theory, back-dating shouldn’t occur too much in startups anymore bc of IRC 409A. Rule 409A is super complex and I’m not qualified to speak to every aspect of it — so forgive me if this over-simplifies things.  Related to employee options, 409A penalizes employees who are granted options at a price less than the Fair Market Value (“FMV”) by taxing the employee on the diff b/w grant price and the FMV, and also hitting them with a 20% penalty tax.  So, there’s incentive for companies to grant options to employees at FMV.

      What companies do to assess FMV and avoid this penalty is after any major event (such as a round of financing), they go to a financial institution (like Silicon Valley Bank) and get a 409A Valuation to assess the price of the CS.  The financial institution takes many factors into account when assessing stock price — valuation at last round, capitalization, assets, etc. — and then comes up with a FMV for the co’s CS.  The co then uses this price as the FMV of the CS when granting options to employees.  In practice, the price may be around 20% of the co’s valuation during the last round of financing, but it’s a sort of CYA in case the IRS comes knocking.

  • http://www.facebook.com/karpenstein Nissim Karpenstein

     The whole premise behind the black scholes model is that if the underlying stock is listed in a public market you can trade the stock to dynamically hedge your position in the option and that the series of hedging trades will yield a profit equal to the volatility.  The problem with receiving options on a startup is that usually the underlying stock is not exchange traded since the company is private and there’s no way to hedge your position or capture the volatility.  I think as an employee of a private company I’d prefer straight equity to options.

    • http://www.cdixon.org chris dixon

      They use the dynamic hedging argument to “prove” the validity of Black
      Scholes, but applying B-S doesn’t require that the stock be
      dynamically hedge-able.

      Sure, if you can receive shares without any tax hit that is like an
      option with strike =0 so obviously preferable.

  • http://www.nabbr.com MattMinoff

    Great post Chris.  I see so many people make these mistakes and not just junior employees!

    Re: strike price – potential employees should ask if the company has done a 409A valuation recently and what the value was.

    I have also seen some founders who are unwilling to divulge how many shares are outstanding b/c it is “confidential information”.  People should not work at a company where they don’t know how much ownership they have.

  • http://technbiz.blogspot.com paramendra

     MBA Friday? :-)

    • http://www.cdixon.org chris dixon

      heh. actually had a few requests for post on options.

      • http://technbiz.blogspot.com paramendra

        Well, then, deliver. :-)

  • Anonymous

    Your description is a bit difficult to follow grammatically. Factually, you also have a few problems. For example, the typical discount to preferred associated with common stock is not a tax rule. The tax rule, so to speak, requires the exercise price for a stock option to be the fair market value at the time of grant in order for the option grant to be non-taxable to the recipient. It is a response to this “rule” that the discount is usually as high as possible without running afoul of the IRS or rather your auditor’s interpretation of the what the IRS might think if your options are ever worth anything and you exercise and sell the underlying stock. Why the discount, as a business practice, is typically around 20% is the more interesting question and really has nothing to do with the IRS specifically. Nor, typically, does it have much to do with Black-Scholes or option volatility.

    • http://www.cdixon.org chris dixon

      agree I should have phrased it better on first point (and you are right)

      never said 20% rule of thumb had to do with B-S. although, now that you mention it, it does happen to be the case that 409a valuations often claim to use option like models to determine FMV of common.

  • http://arnoldwaldstein.com awaldstein

    Chris…interesting and informative and a bit over most employees heads I bet.

    From the employee side, especially for early stage execs, the only really negotiating points are percent ownership (number of options), vesting on change of control, and very rarely changing the vesting cliff and dilution protection. The later two are a bear to negotiate and usually don’t happen, the former are the levers that can be modified and are commonly.

    Only once have I seen a stock plan that had anything other than a 90 day exercise timeframe. It was a year and an oddity, and happily in that case to my advantage.

    • http://www.cdixon.org chris dixon

      yes, perhaps if there is interest I should write a follow up that
      explains these concepts in more detail and in ways that non-finance
      people would better understand…?

      • http://arnoldwaldstein.com awaldstein

        Don’t know the market need but I’ve never hired anyone who really understood this before we spoke. If equity is a significant part of the reason for joining a start-up (which it is), then people need to understand the value before they can appreciate it with any level of detail.

        Designing the stock plan is one thing, having employees (even early ones) understand it is another. I’m talking about the later,

      • http://www.facebook.com/people/Richard-Price/36805589 Richard Price

        It would definitely be interesting to hear your perspective on how to value stock options in a startup environment. There are surprisingly few explicit discussions of how to value startup options online. Most startup founders and employees I know are quite rule-of-thumby about it, and many use different rules of thumb. Just opening up a discussion about the various rules of thumb people use for startup options valuations would be really interesting.   

  • Pingback: What Are Options Stock? | What Are Options Stock

  • Anonymous

    A lot of people overlook restrictions on trading in the underlying stock when determining valuation.  To be able to benefit from volatility, an option-holder has to sell at a high point which, if the valuation is really volatile, probably won’t last too long absent a more fundamental growth trend.  Stock and options in most startup companies are restricted from trading, both contractually and by pesky state and federal securities laws.  So in my view, holding an option in a startup company where trading in the secondary market is heavily restricted (or the market itself is illiquid) has a value that is much closer to holding the underlying equity outright.  Private secondary markets are starting to play some role in liquidity for private company stock- and option-holders, but so far it would seem that 99% of the trading volume on exchanges such as secondmarket is due to the stock of only the most famous and high-flying companies — Facebook, etc. — and is still not an important source of liquidity for most other companies.  If that changes for the better, startup company options could become much more valuable!

    • http://www.cdixon.org chris dixon

      Great point.

    • http://www.facebook.com/people/Richard-Price/36805589 Richard Price

      Yep, great point about the benefits of volatility being mitigated by illiquidity of stock.  

  • Anonymous

     Chris,
     
    You do bring up some interesting Greek and modern history regarding the concept of options as a way to leverage a relatively smaller amount of capital to take advantage of a perceived opportunity in an underlying asset (Thales) or to hedge against a realized exposure to minimize the financial impact of uncontrollable factors upon your more directly controllable core business (Southwest Airlines).  Both indeed were derivatives, with Thales exercising an option and SWA utilizing futures, and both have a value that is derived explicitly from the volatility of the underlying asset – olive press rental (low volatility) and future oil prices (high volatility). 
     
    Mathematically speaking, Fischer Black and Merton Scholes did write a paper in 1973 addressing the concept of pricing explicitly pricing options, which Robert Merton then expanded upon and coined the term “Black-Scholes” option pricing model.  The concept, which you accurately describe, is that with a higher volatility, there is a higher probability that the underlying asset will cause the option to become “in-the-money” or to have a positive value at exercise (proceeds received are larger than the payment to exercise).  Thus, if you can accurately predict the future volatility of an underlying asset, you can correctly price an option.  Of course, the broad assumption is that you can accurately predict future volatility, and the most common practice is to look at historical volatility as an indicator of future volatility.  This is akin to predicting the stock market by looking backwards – a difficult, limiting, and inconsistent practice.
     
    As a tremendously powerful theoretical model, the B-S model has been adapted for use in more ways that its originally intended purpose.  One such application of the B-S model has been through 409A, which requires the valuing of common shares in a private company for the intended purpose of setting a strike or exercise price for the employee options such that the tax liability can be deferred until exercise.  While the understanding of 409A continues to evolve and best practices continue to improve, the B-S model has increased in its adoption for the valuing of common shares within the 409A context.  The primary reason for its adoption, which is partially described in the posting by SCrockett, is that for an early stage company (pre-product/pre-revenue/pre-profitability), the primary indicator of value is the price that an investor is willing to pay for preferred shares, as actual money exchanged hands.  The problem is that employees are issued common shares, not preferred shares, thus the question is how to derive the value of the common shares from the price paid for the preferred shares.  Further complicating the idea of deriving a common share price from a price paid for a preferred share is that different investors investing in different start-ups take different economic and control rights with those preferred shares.
     
    With the B-S model, theoretically, the value of all of the economic rights and preferences of the preferred shareholders can be valued independently.  As such, value can be calculated for all share classes, both preferred and common, within the constraints of a B-S model.  Therefore, by “solving” to the price paid for the preferred shares, incorporating each of these economic rights, an implied value for the common shares can be calculated.  As for the “20%” rule of thumb, it is an oversimplification, as the ratio of common to preferred depends on numerous factors, including, but not limited to, the preferred rights and preferences, the capital structure, the stage of the company, and the history of the company.  However, when looking at really early stage companies (Seed, Series A), the 20% rule is a useful approximation, realizing that certain factors will influence that percentage up or down accordingly.

    • http://www.cdixon.org chris dixon

      thanks for taking the time to write such a thoughtful comment. and I
      agree with your points.

  • http://trade-4-target-china.blogspot.com/2011/05/trade4target-performance.html Trade4Target

    Hey, very nice site. I came across this on Google, and I am stoked that I did. I will definitely be coming back here more often. Wish I could add to the conversation and bring a bit more to the table, but am just taking in as much info as I can at the moment.
    Thank You
    Regards:
    Trade4target

  • http://anyessays.com/writing/essays Essays

    Thanks for the suggestion – I’ll make sure it’s included in the thinking.

  • http://anyessays.com/writing/essays Essays

    Thanks for the suggestion – I’ll make sure it’s included in the thinking.

  • BuyGiftsItems

    Further complicating the idea of deriving a common share price from a
    price paid for a preferred share is that different investors investing
    in different start-ups take different economic and control rights with
    those preferred shares.
    Buy Gifts Items

  • http://thesis911.com/ thesis writing

    thanks fort he post) very interesting information)

  • http://termpaperwriter.org/term_paper term paper writing

    Hi, nice post. I have been pondering this topic,so thanks for sharing.