Understanding the Calculation of Stock Options: When Should You Include Preferred Shares?

When a company offers stock options, one critical decision you must make as an optionee is to determine the correct denominator for your calculations. This denominator is the total number of shares outstanding, either common or preferred. The choice can significantly impact the value of the options you are offered. In this article, we will delve into the details of how to calculate the correct number of shares for your stock options, considering both common and preferred shares.

The Importance of the Denominator in Option Valuation

One fundamental principle to remember is that the larger the denominator, the more shares you need to make in order to achieve the same increase in the numerator. In other words, the denominator represents the total number of shares outstanding, and the numerator represents the number of shares subject to the option. The higher the denominator, the more difficult it becomes to achieve the desired outcome.

Minimum Requirements: Common Stock Only

At a minimum, the denominator should be the number of shares of common stock outstanding. This is the most straightforward and conservative approach. For example, if there are 1 million common shares outstanding, and you are given options to purchase 10,000 of these shares, achieving a 10% increase in the value of those shares would be more challenging compared to the same increase in a scenario with only 500,000 common shares outstanding.

Including Preferred Shares: The Pros and Cons

There are scenarios where including preferred shares in the denominator can be advantageous. Preferred shares often come with voting rights and liquidation preferences, but they do not necessarily participate in the upside of the company’s stock value. However, they may still be considered part of the denominator for valuation purposes. Here are some considerations when deciding whether to include preferred shares:

Company Size and Structure: In larger companies with a more complex capital structure, including preferred shares can provide a broader perspective on the overall company value. However, in smaller companies, this may not be necessary. Preference and Voting Rights: Preferred shares typically come with additional rights, which may dilute the value impact of your common stock options if you are to be counted against them. Market Perception: Including preferred shares in the denominator might lower the denominator, making it easier to reach your stock option goals. However, this could also mean that your options are less valuable as they represent a larger share of the company.

Practical Considerations and Strategies

Before making a final decision, consider the following practical steps:

Evaluate the Company's Capital Structure: Understand the company’s current capital structure, including the number and types of outstanding shares. This will help you make an informed decision. Consult Legal and Financial Advisors: Seek professional advice to ensure that your decision aligns with the company’s operational goals and legal regulations. Consider Long-Term Goals: Think about the short-term and long-term implications of including preferred shares in the calculation. This can help you make a more strategic decision.

Conclusion

The decision on whether to include preferred shares in the calculation of stock options depends on various factors, such as the company's structure, the rights attached to the preferred shares, and your long-term goals. At a minimum, the denominator should be the number of common stock shares outstanding. However, in certain scenarios, including preferred shares can provide a more comprehensive valuation. By carefully evaluating these factors and consulting with experts, you can make an informed decision that benefits you in the long run.

Stay informed and proactive in managing your stock options to maximize your potential in the equity-based compensation landscape.