From Erin, Paysa’s Equity and Compensation Expert
It’s important to make sure we’re looking at this question from the same perspective. When you say that the options are “discounted,” I assume you mean as compared to the stock held by investors. I am also assuming that you are talking about a private startup company. In that case, it’s true that employees – especially founders – purchase their stock at a price much lower than the investors. But the price of employee stock and the price of investor stock represent two completely different values.
What I am calling “investor stock” is the preferred stock of a company that is sold to an investor in a financing. The investor negotiates for certain economic and control rights that give the preferred stock advantages over the common stock. For example, investors may negotiate a board seat and veto rights over certain management decisions. Also, preferred stock always gets paid before the common stockholders. This is why investors pay a premium for their stock. The price they pay per share for their preferred stock is based on the value that the investor places on the company at the time of the financing. This number, as I’m sure you already know, is really more of an art than a science.
The stock held by employees is usually common stock. As mentioned, common stock does not have the same preferential rights as preferred stock and it’s always second in line to get paid if the company is sold. The value of common stock changes over the course of the company’s life. In the beginning, common stock is sold to founders at dirt-cheap prices because the company is worth essentially nothing. But as the company grows and increases in value, the common stock value increases as well.
Companies hire independent valuation firms to issue reports called 409A valuations, which determine the “fair market value” of the common stock. The fair market value is just what it sounds like – the fair value of one share of stock if it was sold on the market. A new valuation is usually completed every 12 months or after any major event, such as getting a term sheet or signing a large deal.
Most companies issue stock options to employees at a price equal to or above the fair market value in the 409A report. This is done largely for tax compliance reasons, though intuitively it makes sense to sell employees stock at the fair market value. Because this is the general lay of the land, it’s not really fair to say that employees get their stock at a “discount.”
Valuing employee equity can be difficult, though. Check out this little guide on Paysa if you’re interested in reading more!