transcripts/40-Scheme-design-practice---numbers.srt

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You should do these calculations in your journal yourself as we discuss them.

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Morgan and Catherine decide that the right sales head needs to be in their 40s and would

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probably be drawing around $200,000 per annum currently, but they can only afford to pay

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$75,000 per annum.

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So they need someone who resonates strongly enough with their non-financial vision to

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consider that salary and top that up with an attractive stock option strategy.

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They consider this role to be of the highest criticality rating, that is A, and agree

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that an attractive intended benefit for such a person should be at least eight times their

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current annual worth.

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They realize that this amount is not a guarantee from their side, but will be realized only

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if their business grows to a certain value.

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Seeing the right person who resonates with their values and vision is key to achieving

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that growth, and if they can find one, the financial benefit must also be attractive.

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A benefit of eight times in four years means that the sales head should be able to make

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$1.6 million after four years if things go as planned.

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But what is that plan?

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They need to drop their financial projections next.

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They have only started up a few months ago and have a half-finished product with them.

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They estimate their growth over four years and believe they would raise venture capital

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during this period.

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This would increase their number of shares, so they estimate the share capital to increase

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to 40,000 shares, from the current 10,000 shares in four years.

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They estimate that given the current market saturation in the education sector, it might

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take them some time to make a dent with their uniqueness.

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They estimate their company valuation at $40 million after four years.

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$40 million divided by 40,000 shares leads to a share price of $1,000 per share after

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four years.

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Since the intended benefit to the sales head is $1.6 million, they would need to grant

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1,600 options, assuming the options are granted at, say, 1 cent or almost zero exercise

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price today.

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So the arithmetic is done and now they have a number, 1,600 options.

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But then they look carefully and realize that 1,600 options amount to 16% of their current

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capital of 10,000 shares.

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And this is just the sales head we are talking about.

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They also need to grant stock options to a few other team members.

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Something is not right.

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So they start looking at each number more carefully this time.

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First, the intended benefit.

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They have considered it at eight times the current market worth of $200,000, which comes

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to 1.6 million.

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They could reduce that, but they realize that the intended benefit must be really attractive,

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so for now they decide to keep it at 1.6 million and consider the other figures first.

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Next, they notice they have considered the total number of shares in the fourth year at

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40,000 shares.

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They start analyzing that number and conclude they should be judicious by raising capital

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from the investors and also raise it at a good valuation so they don't dilute much.

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But that would mean delivering a really strong product with a healthy revenue.

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That would come not just from adding more people to the team, but by strengthening the

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core of the product.

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So they make a mental note that if they wish to reduce their equity dilution but still

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make the company valuable, they need to solidify the vision to attract the right people and

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think deeply about the value proposition of the product.

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They revise the total number of shares in the fourth year to 20,000 shares, from 40,000

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shares.

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Then they consider the valuation of 40 million dollars in the fourth year.

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Now, this is not just about changing 40 million to something else so that the numbers fit

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well.

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It tells them something very important about their stock options strategy.

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If they wish to give out 1.6 million as intended benefit, they have to get to a much higher

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valuation.

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The valuation of 40 million is certainly a good number, but at that valuation they may

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not be able to justify an intended benefit of 1.6 million dollars.

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So either the intended benefit needs to reduce or the value per share needs to go up.

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As they still wish to preserve the intended benefit, they revise the fourth year valuation

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to 1.60 million dollars.

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But they now make a mental note that this would mean a certain amount of revenue to be brought

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in.

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And they need to ensure even more that their product is far better than what others have

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an offer.

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This does not mean more advertisements and more customer phone calls.

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It means more contemplation on how that product could become valuable.

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More physical labor, more resources without any additional intellectual labor may not

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help much.

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By contemplating deeply about their product, they can significantly increase its value

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proposition, enhance valuation without spending a single extra dollar.

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Reducing the fourth year shares to 20,000 and increasing the fourth year's valuation

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to 160 million dollars brings down the number of options to be granted from 1600 to 200

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options, which is 2% of their current capital and 1% of the capital in the fourth year.

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Now if the eventual valuation were to get to a billion dollars, then the employee ends

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up making much much more.

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Similarly, if they were to reach only 40 million in valuation, those 200 options would

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fetch much lesser.

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So their strategy rewards the employee reasonably in case of a certain growth trajectory and

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rewards them exponentially in case of an exponential growth.

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Next they take up the other potential team members and rate them A, B or C depending upon

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the criticality of their role and apply a descending multiple to compute their intended

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benefit.

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The process is the same.

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Now they could further reduce the number of options by reducing the multiple or increasing

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the valuation in the fourth year or decreasing the number of shares in the fourth year even

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further.

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But what you need to focus on here is the process.

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Look at how the intended benefit can sometimes guide you to take decisions about your business.

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As far as possible, try not reducing the intended benefit.

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The key takeaway is let your vision and intellectual capital drive your stock option

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strategy.

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Use your non-financial vision to attract the right people.

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Use deep thinking to infuse value into your product.

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Valuation will take care of itself and your journey will be much more meaningful and enjoyable.