How to Calculate Stock Option Grants in a Startup
Startup founders often assume that they can “trade” cash salary for stock options. The logic usually sounds like this:
“We cannot pay you an extra $10k in salary, so we will give you options for 10,000 shares at a $1 exercise price. That way, the option grant represents the same value.”
This logic is intuitive, but it’s wrong. It also leads to confused employees, misaligned expectations, and compensation structures that do not reflect economic reality. If founders want to use equity compensation responsibly, they must understand what stock options are, what they are not, and how to properly calculate an option grant that offsets a reduction in salary.
Stock options are not a direct substitute for cash compensation. So, if you want to avoid common mistakes founders make when evaluating option value and incentivizing employees and contractors with equity compensation, then you need to learn how to structure a fair option grant.
Stock Options Are Not Compensation in the Way Founders Think
A stock option is a right to buy shares in the future at a fixed exercise price. It is not cash. It is not the same as stock. It is not a guaranteed benefit.
A stock option only becomes valuable if three things happen:
The company increases significantly in value.
The employee remains long enough to vest.
The employee pays the exercise price in order to convert the option into real shares.
That final point matters. To benefit from an option grant, an employee must eventually spend money to exercise the option. This is the opposite of receiving compensation.
Founders often overlook this because they focus on the potential upside. The upside can be meaningful, but it is highly uncertain. For many employees, the option grant will create zero financial benefit if the company never exits, if it shuts down, or if the employee leaves before vesting.
This creates a structural difference. Cash is certain. Options are uncertain and require the employee to pay money to unlock any value.
This is why options cannot be seen as a dollar-for-dollar substitute for salary.
Why “cash = strike price * shares” is wrong
A common mistake is to equate the salary sacrificed with the number of shares multiplied by the exercise price. For example:
“We reduced compensation by $10k, so we will grant 10,000 options at $1 per share.”
This ties the option value to the cash reduction, but it does so in the wrong direction. The total strike price only indicates the money the employee must pay to purchase the shares. It does not represent value the employee receives.
In this example, the employee must pay the company $10k to obtain the shares. If the company exits later at $1.10 per share, the employee’s total upside is only $1k. They gave up $10k in guaranteed cash to receive a $1k benefit years later, assuming the company succeeds and assuming they have $10k available at the time of exercise.
This is not a fair trade. It is not even a rational one.
Employees understand this intuitively once they think through the math. When founders mistakenly rely on the “cash saved equals strike price times shares” approach, they inadvertently create compensation structures that underpay people and generate future resentment. A more accurate method is needed.
How to calculate a fair option grant when reducing cash compensation
We’re not suggesting founders should stop using options. Stock options remain one of the most effective tools for creating alignment, recruiting talent, and rewarding long-term commitment. Options protect the cap table from unrestricted share issuance and reinforce a performance-driven culture.
Founders simply need a better model for calculating option value.
Below are three legitimate methods startups use to determine a fair option grant that offsets a cash reduction. These methods are grounded, realistic, and consistent with how sophisticated companies approach equity compensation.
Method 1: Use a discount rate to estimate present option value.
This method starts with the idea that the true economic value of an option is significantly lower than the underlying share value. Reasons include:
exercise cost
vesting risk
illiquidity
failure risk
tax timing
long time horizon
Many startups assume the present value of options is roughly 15-35% percent of the value of the underlying shares.
To offset a $10k cash reduction:
Divide $10k by a discount rate.
That number represents the “equity value” the option grant should approximate.
Example with a thirty percent discount: $10,000 divided by 0.30 equals $33,333 of implied equity value.
If the company values itself at $10 per share: $33,333 divided by $10 equals 3,333 options.
This model is economically coherent and easy to apply.
Method 2: Use percent-of-company benchmarks.
This is the most common method in practice and often the most intuitive for founders.
Each role in a startup has a typical ownership range. For example:
early engineers: 0.4 to 1.5 percent
mid-level contributors: 0.1 to 0.4 percent
senior hires at Series A: 0.02 to 0.2 percent
advisors: 0.1 to 0.25 percent (usually restricted stock)
If you want to reduce cash compensation by $10k, you simply move the hire toward the upper end of the range.
This protects internal consistency, avoids misleading valuation math, and ensures compensation is tied to role seniority rather than cash fluctuations.
Method 3: Apply a risk haircut based on early-stage valuation dynamics.
Investors value early-stage equity with a significant risk discount. Founders can adopt similar logic when determining fair option value.
A reasonable haircut is four to ten times the cash value being replaced.
Meaning, if a candidate gives up $10k in salary:
Multiply that by five to get $50k of equity value.
If the company’s per-share value is $5:
$50k divided by $5 equals 10k options.
This method is simple to understand and aligns with how early-stage investors think about risk.
A Clean and Honest Rule Founders Can Use
If a company needs to reduce cash compensation:
Start with the market-standard ownership range for the role.
Increase the grant toward the high end.
If the cash reduction is significant, apply a risk multiplier to increase the grant.
Avoid describing the grant as a direct replacement for cash.
This creates clarity and fairness without overpromising.
The Bigger Message for Founders
Options are powerful. They create long-term alignment, reward early contributors, and reinforce ownership thinking. But they are not cash. They require employees to take real financial risk. Founders should not treat options as a simple currency exchange.
A thoughtful approach to stock option valuation is one of the most important parts of equitable startup compensation. It influences culture, retention, trust, and future hiring. If companies calculate option grants fairly and communicate them honestly, employees understand what they are receiving and why. That transparency is the key to building a cohesive team in an early-stage company.
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