Stock Options — Why It’s Time for Startups to Replace Them.

The technology half-life is incredibly short, yet stock options have remained a central compensation model for startups long past true usefulness. It’s time to dump them, we can do better.

This is a 10 minute read providing background and context for why options are broken and why something new, a version of RSUs that I call SRSUs (Startup RSUs) should be created to make equity compensation useful.

I am a major fan of the uniqueness and power of alignment that stock options brought to employees, management and shareholders. Over time, however, that alignment and benefit degraded to the point where stock options have become a lottery ticket rather than compelling & predictable wealth creation. Recognizing this, most large tech companies have replaced stock option programs, yet they remain the primary model for small to mid-sized tech startups. So, what’s the disconnect?

Stock Options Worked Very Well.

Way back, stock options were provided to executive leadership, and over time, to nearly all full-time employees of tech companies. The basic structure involves the company issuing the right for employees to buy stock in the future at today’s price, set to a vesting schedule. If the value of the stock rises over the next several years, the employee buys vested stock from the company at the initial price and sells it at the current, higher, price. The difference is a financial gain and is taxed at ordinary income. You may hear someone brag about holding options worth $1M, but, typically, the amount they can put in a saving account would be significantly less. For example, if the cost of the option was 20% of current value, 80% would be a gain and as much as 40% paid in taxes, leaving 40% — $400,000 as the true value of the option.

I joined Microsoft shortly after they began to popularize stock options for all full-time employees as public company in 1986. Over the next dozen years, Microsoft’s stock price soared creating tremendous wealth for employees, often far in excess of their salary. Microsoft received very large tax deductions while also getting cash from employees who acquired the highly discounted stock. Additionally, employees were motivated to help the company perform financially well, knowing that it would further fuel a run up in the value of the stock. Since Microsoft’s IPO, a share of its stock has risen a stunning 147,000%. Options, issued at any point, would eventually be very valuable.

The financial velvet handcuffs were meaningful and voluntary employee turnover was likely lower than what was considered normal for the tech industry. Other technology companies expanded stock option programs to the broad employee base and, as long stock prices rose, the option program appeared to a beautiful model for everyone.

Then They Broke.

So, what happened? There’s an adage that employees do what you pay them to do. That is, behavior will heavily be influenced by the compensation model. Pay large bonuses for large contracts and you’ll get large contracts, regardless of profitability. Pay for profitable sales and the sales reps will only focus on profitable sales but growth may suffer. Stock options provided employee alignment with shareholders as they were both focused on increasing the same metric: stock price. All good, right?

Over time, four realities transpired and changed the game.

Number One: Stock options are an incentive only when they have value, and that only happens when the stock price continues to increase. Underwater options are just demoralizing. Great in bull runs, worthless in bear markets and arguably more correlated to the overall market conditions than specific company performance. There are difficult periods where the stock value doesn’t nicely reflect the progress of the employees. It can be confusing to employee incomes to have dramatic and uncontrollable swings in value.

Number Two: Stock options are compensation expense, not a tax deduction. In 2005, accounting rules changed to recognize this expense, however, most companies treated this expense separately and do not include in their “adjusted EBITDA” performance numbers. Either way, options are now a drag on earnings instead of an enhancement.

Number Three: There are two scenarios where employees could write checks and end up losing their own cash. One is when they want to get capital gains taxation, do a 83(b) election, and buy the stock from the company at grant. The other is when they leave the company, acquire vested stock, pay taxes on the gain, and hope to sell at a future liquidity. For example, if they bought $100k of stock and paid $50K in taxes on the gain, they now have $150K of their own money at risk. Most people walk away from vested stock simply because they don’t have, or can’t put, their own cash at risk.

Number Four: Employee retention is directly influenced by the value and timing of the stock options. The standard four year vesting cycle with a one year cliff influences behavior. Also, in a successful company with a rapidly rising valuation, it’s almost certain that future grants will be priced high and be far less generous ownership and, therefore, much less valuable. So, especially in the upside case, there’s little financial reason to stay longer than the initial grant vesting.

Well, do they work? They can provide wealth, but only for a small number of people who hit the stock option lottery — essentially, the early employees with respectable grant ownership of rapidly appreciating companies. That’s rare but makes all the news.

The vast majority of stock option grants issued will be worthless or worth very little. I interviewed an engineer who was leaving FitBit, a massively successful startup tale. Its market cap peaked over a $10B valuation but quickly settled down prior to employee liquidity and now trades around $1.3B. Even then, a great success. The employee’s post-tax shares, however, were nothing better than a nice bonus.

Simply put, if you compensate with lottery tickets, your employees will leave when they think the number may not pay off. Worse, they may start to think of your company in the same way you compensate them — a long shot random opportunity.

I’ll provoke by saying that many startup CEOs don’t even believe in their own stock option programs. A number of high profile CEOs often sell some of their stock to investors as part of an investment round. If they really believed, they’d be buyers not sellers. I know there can be compelling reasons for this, but when a CEO sells and his own employees can not participate, it’s a major disconnect between them.

Large Companies Ended Options, But Startups Couldn’t Do The New Plan.

For these and other reasons, in 2003, Microsoft ended the stock option program and replaced it with restricted stock units (RSUs). Shortly afterwards, Microsoft co-founder, Bill Gates was quoted as saying he wished they had never issued options citing the highly volatile lottery like program, essentially saying “either you can buy 10 homes or none at all”. Now, nearly all large technology companies, public and private, now offer restricted stock units rather than stock options. One notable exception is Netflix, which has one of the most innovative stock option offerings and is quite thoughtful about aligning the interests of shareholders, management and employee.

Do they retain good talent? I’d argue that it’s not clear and it’s possible that it has a negative impact— the 4 year vesting schedule has become the retention guide and beliefs about staying at the company focus on a vest schedule rather than company fundamentals or overall career satisfaction. Employees now seek a portfolio of lottery tickets, getting initial grants at four to eight companies in their career. I joke about it as “VAR” for “Vest and Repeat” or, less nicely, “Vest and Run”. In the success case, once an employee begins to understand that future grants are not likely to generate anywhere near the income of the initial grant, they focus on maximizing value of the initial grant and then seeking out the next grant at a new company. It’s no surprise that the likelihood of employment after the third year is only 50%.

After decades of involvement and BOD roles with startups and after founding and leading my own startup, I believe the stock option model doesn’t work for startups. Compensation reward should be tied to contributions & time with the company, not the luck of being employed at the right time in the company history. Essentially, long term contributions to an enduring company should deliver long term wealth and be more attractive to top talent than the roulette wheel of stock option program.

Before going public, United Parcel Service (UPS) created meaningful wealth for many employees, from drivers on up. As a profitable and private company, they assigned a book value for their stock and allowed over 300,000 employees to capture a share of value creation during their employment. When the employee left, they were paid out in cash as their equity was repurchased by the company. It was a strong and clear message to employees that they, not former employees, created shareholder value. This excellent model worked because UPS was profitable, unlike most tech startups, and had the cash to repurchase ownership.

If the goal was to provide meaningful and fairly consistent rewards based on company performance, RSUs got the job done. Stock options, on the other hand, provided fantastic value to a small lucky group of employees and nearly no value to the vast majority.

Startups and VCs are starting to recognize that stock options are losing their effectiveness in recruitment and retention of the best talent. RSUs, used at large companies, doesn’t work at most startups since they can’t use their cash to buy back RSUs. Additionally, RSUs cause force a sale of stock at vest, in order to pay taxes. Essentially, you are forced to sell regularly even if you believe in the potential in the stock, a significant disadvantage to stock options.

So, what to do?

A new equity model should be created — one that provides benefits to long-term employees, shareholders and company management and that provides powerful recruitment and retention.

To execute my suggestions, a team of lawyers, accountants, tax experts, VCs and entrepreneurs would need to translate this framework into a binding and effective program. At my startup, we implemented an equity model that would have yielded much greater value to employees. Basically, our equity plan, while not perfect, allowed employees to have no strike price, pay capital gains tax rate and never have a situation where an employee would have cash at risk. It required, however, that we operated a LLC, not a C-Corp, and that proved different enough and complex enough for many to comprehend. Reid Hoffman & Josh Elman, partners at Greylock, were terrific in allowing me to try it out at Otto and learn a number of important lessons that are central to this new model.

Enter SRSUs- a better plan.

This new model, I’ll call “SRSUs” — for Startup RSUs. It works as follows:

Startup C-Corp (note, this is a traditional C-Corp, not a LLC) issues SRSUs to employees, which vest on two triggers: 1- one year monthly schedule; 2- at liquidity event.

Grants are issued annually, as a percentage of salary, not tied to individual performance. Employees can substitute grants for cash income (by reducing their salary), effectively purchasing grants with pre-tax dollars.

For exceptional executive hires or key talent, an additional DRSU grant could be offered with a multi-year vesting schedule — anywhere from 2 to 10 years. It’s also possible to provide traditional stock option grant as an additional lottery ticket to key employees simply to provide access to greater upside.

Once a year, existing investors (VCs) are invited to acquire time vested employee SRSUs to a max percentage (~25%) of an employee holdings at a price set by the buyers. It’s a simple and fast Dutch auction where employees, on equal terms with the CEO, can get liquidity on their holdings. That auction would be considered a valid liquidity event providing full vesting of eligible shares.

The offering price is set by the auction. Since it is a free market, it’s possible investors may offer a lower price for shares than the prior year, or they may not offer any price at all. The clarity of a real market price set by sophisticated and skilled insiders may eliminate the need for annual 401A valuation reports. It also provides direct investor & important feedback to the team on their performance.

When an employee leaves the company, they get to keep their time-vested SRSUs but can no longer participate in the annual investor purchase program and must wait for a major liquidity event — either IPO or company sale. Within 3 months of termination, however, investors have the option, but not obligation, to purchase the departing employee’s entire stake at the last auction price. The ex-employee is not guaranteed liquidity when they leave and they may have have to wait until an overall liquidity event.

Automatic annual grants provide a reasonably predictable stream of SRSUs to employees. Performance bonuses could also be converted to SRSUs by the employee.

If an employee wanted, at the annual auction, rather than selling eligible shares, they could simply acquire the shares. Ordinary income tax would be due, but by holding for at least one year, future gains would be taxed at capital gains rate. A powerful investment opportunity for a bullish employee.

Key benefits:

  • Risk free & valuable grants to employee (RSU-like)
  • Not subject to standard option strike price volatility
  • More fair & sustainable for growth companies
  • Less dilutive than standard option programs
  • Annual liquidity program for all vested employees
  • Taxable only at liquidity, not time vesting
  • Ownership focused on current employees & investors
  • Standard C-Corp structure with modified RSU program

These changes would provide new opportunities for employees at venture funded startups to participate in annual liquidity events, share in valuation growth of the company and align interests among shareholders, employees and management. Additionally, it should provide better economic incentive for employees to stay with a startup rather than pursue a new company every two to three years.

These changes won’t solve all the problems associated with stock options but addresses many of its weaknesses and underlying ineffectiveness. Stock options have all but disappeared in the tech industry but they’ve clung to life within the startup world. They are no longer effective and SRSUs, or another innovative model, is needed to replace them.

If you are a CEO, attorney, or venture capitalist and want to give this a try, reach out to me. While this was a lengthy description, there’s a great deal of nuance and learnings along the way and I focused on the core items. I’d be happy to help out in a way and help you advance the industry in this way.

Technology & Product exec, former CEO/founder, @samjadallah

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