Is there a generic formula I can apply to determine fair pre-IPO stock option grants based on the company’s size and # of fully diluted shares?

Chris Barsness, startup, finance, law, and tech nerd

That is a common, but complicated question.  The key component is what is the valuation of the company.  With a private company, that can be somewhat subjective since there is no market to see what others are willing to pay for the stock.  If they give you any information about their valuation or what any recent shareholders paid for their stock on a per share basis, that can give you some insight into the value.  

The most common stock option valuation methodology is the Black-Scholes option pricing model, but that is beyond what you really need to determine as that is more of an accounting determination for the company.  There are numerous posts about option compensation, so that can give you some information, but it sounds like you have a general knowledge from your prior work.

Think about what portion of compensation the options represent.  If the estimated fair market value less exercise price of options times the number of shares in the grant is not much compensation compared to what you expected, you need to ask for more.  Don't think about the number of shares as a percentage of the company as that can change significantly and it doesn't really represent the value to you.  Also realize that there is a certain opportunity cost lost for your time in exchange for the value of the options if you never get to exercise the options (i.e. company stays private or other events).  

In terms of your curiosity from the company's standpoint, once they hit certain amounts of option grants, there can be added reporting obligations from a securities law perspective and they have to account for the value of the option grant as compensation expense.  In a private start-up, those non-cash expense amounts are not necessarily that big of a deal, but management still needs to report to the board and shareholders, so they can't just give away the company in stock options.  Plus, if they grant one employee a significantly different amount, they may face some upset employees as well.

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