After 7 startups full-time and another 20+ as an investor/advisor, it’s become clear to me that startups should do a better job with all aspects of their incentive stock compensation, and not just follow convention because it’s “what we’ve always done.” This has been on my mind for a while, and after a recent Twitter exchange with a few VC/angel friends, I’ve been thinking about how startups can adjust certain aspects of incentive stock compensation to be more favorable to employees as well as the company. There are four specific areas of focus that I think are ripe for change:
- Cap table transparency for all
- Early exercise for early employees
- More than 90 days to exercise after departure
- Vesting schedule revisited
[also should add company buyback rights (no) and acceleration upon acquisition (100% double-trigger) as noted below in the July 31, 2015 update]
1. Cap table transparency for all
Let’s say Calvin decides to leave Startup #1, where he has 10,000 stock options vesting over 4 years, to join Startup #2, where he has been offered 20,000 stock options vesting over 4 years. He thinks “wow, that’s double the stock!” Uh, no. What he failed to understand was the 10,000 options represented 1% of the fully diluted shares of Startup #1, whereas the 20,000 options only represent 0.5% of the fully diluted shares of Startup #2. So he ended up with less ownership of the company. There are a lot of very savvy startup employees out there who know to ask the right questions, but there are also many who don’t know which questions to ask.
I can’t tell you how many times I’ve made an offer and a potential employee does not know the right questions to ask in order to understand the true value being offered. I go out of my way to ensure I explain the nuances in each case, and these potential employees are so happy someone has finally explained this to them.
Employees should be informed, not duped. When a potential employee is joining a startup, they should be told what percentage of the company their stock option grant represents, and how much stock is owned by various groups (preferred investors, founders, employee pool). This is sometimes difficult in capped note situations where a valuation has yet to be determined, but an estimate can be made in those cases. Note I am not suggesting that every employee’s stock option amount be exposed to every other employee.
2. Early exercise for early employees
Employees should be allowed to exercise their stock options early. There are huge tax advantages to exercising stock options when granted, even if they have not been vested. There are definitely nuances here, but it’s my belief the benefits to the employees far outweight the potential issues for both the employee and company. It’s possible this may need to be limited to the first 50 or 100 employees, but for the early employees who have the most to gain (and lose to taxes), this should be standard practice.
3. More than 90 days to exercise after departure
The day came and went like any other day. It was a Wednesday. I had been debating back and forth whether or not to exercise the stock options of my former employer before they expired. I chose to let them expire for a variety of reasons including the possible risk/reward of writing a check for tens of thousands of dollars, the preferred investor preferences stacked in front of the common stock, and my guess at the potential exit value of the company. Only time will tell if that was the correct decision.
Countless startup employees go through this same calculus typically 90 days after their last day of work at a company. For an employee who spent 3 years working extremely hard for a startup to walk away with no stock because of an arbitrary 90 day exercise window seems odd to me. Maybe that employee has decided to go back to school for an advanced degree. Or maybe life has interceded and a move across the country is necessary due to family matters. Or maybe they decided to go start a company of their own. As a multiple-time founder and CEO, it always hurts to lose an employee, but to be vindictive on the way out, especially for a great performer, seems petty and short-sighted. They worked hard, they vested those shares, and it seems that they shouldn’t have to make an arbitrary decision with little data 90 days out.
If you early exercise, you don’t need this right. But not every employee will early exercise due to the cost involved upfront and potential tax consequences. 90 days is too short. Pinterest’s practice of providing 7 years to exercise after you leave (provided you stayed at the company for at least 2 years) seems like a reasonable proposal. Others propose 10 years. I’d stick with 7 years for now.
4. Vesting schedule revisited
This one is a little more controversial because it’s not necessarily better for employees. Standard vesting schedules are typically 4 years vesting monthly with a 1 year cliff. That means the employee gets 25% of the options every year, and some argue this structure is fine. However, some founders believe that only the employees who stick around for the long haul should have stock in the company. While I believe that’s shortsighted, there are merits to this line of thinking as it rewards employees for longer-term commitments. If companies are going to give 7 years after you leave to exercise, it seems that employees should be willing to give a little on the vesting side. Sam Altman talks about a method of backloading vesting here and coincidentally, this is exactly what we discussed in our recent Twitter exchange. The idea would be that 10% vests after the first year, then 20%, 30% and 40% in the subsequent years. I’m fine with either the standard 25% per year, or this new backloaded vesting schedule. I worry a little that potential employees will react negatively to this backloaded structure, but it’s worth exploring.
A few other random thoughts. My goal here was to spur debate about these topics and to improve the situation for both startup employees and companies. Even though I plan to advocate and implement these practices moving forward, I’m certainly not in a position to mandate what others should do. But I would argue that if you’re thinking of joining a company that doesn’t adhere to similar principles, you should definitely think twice before joining them!
One option that was suggested on Twitter was as follows: as they did with SAFE docs, Y Combinator is in a position to do something about this. Another proposal was to add fields to AngelList’s recruiting site and let the free market take over. I think both of these would be steps in the right direction.
Also, for those who haven’t seen it, Venture Hacks from the AngelList guys is a great resource for startup employees. Lots of great info about stock options, vesting, etc.
Thanks to the VCs and angels who reviewed this post (you know who you are!). If anyone has other suggestions on this topic, I’d love to hear them. Please comment here or tweet to @beninato. Recommend button presses always appreciated!
Update July 31, 2015
Thanks to all for the great feedback across all channels. There’s an excellent comment thread over on Hacker News: https://news.ycombinator.com/item?id=9977092
Based upon the comments I’ve received, I should make a few clarifications:
- As I expected, the most contentious issues is the backloaded vesting. Several people pointed out their concerns about getting fired in year 3 or 4 because a greedy company wants to save on stock. If you’re doing a great job, only an idiot would fire you to save a few points of equity, and if you’re working for an idiot, maybe you should be happy to be gone. I can tell you that as a CEO, I’ve never looked at a situation and said “how do we preserve a little bit of equity by firing some people?” The top of mind issue for a growth company CEO is “how do we retain the people we have and hire more.”
What I neglected to say in the original post was that employees should get more stock than a typical employee, subject to the new vesting schedule. Sam Altman from Y Combinator does a great job in this post talking about a backloaded vesting schedule. Worth a read.
Another alternative vesting schedule that was suggested was 20/25/25/30%. Not quite as aggressive as 10/20/30/40 but accomplishes some of the same.
- In my haste to get this posted, I completely neglected to talk about an important topic: buyback rights. In recent years, I’ve heard a few horror stories about employees leaving a company only to have their vested shares repurchased at the same price they paid for them…in other words, they get nothing for their vested shares. Skype is probably the most evil example of this happening (you can read more here). I can think of no situation where it’s fair for the company to be able to buyback shares because they feel like it. The whole premise of working for a startup for a year or four years is to vest your stock options and hope that they are someday worth a lot. The one year cliff is designed to weed out hiring mismatches. After that, every employee deserves to keep whatever stock they have vested.
- One other omission is the topic of single- or double-trigger acceleration during a change in control (acquisition). Single-trigger means if an acquisition happens, you get some percentage of your remaining shares. Double trigger means if an acquisition happens and you are terminated without cause or good reason, you get some percentage of your remaining shares. Some people argue for 100% single-trigger upon acquisition. I think that’s too aggressive. Yes, the acquiring company can create new incentive structures as part of the deal, but odds are that early stock will be very valuable. My preference is to have 100% double-trigger acceleration. If a company that you have helped make successful gets acquired and you are let go as part of that, it seems unfair that you’re not being given a chance to vest into those very valuable shares. At a minimum, I’d suggest either a 12 month acceleration in the case of a double-trigger or 50% of the remaining shares.