Stressing Over Vesting?

I had a brief exchange on Twitter with my friend and former colleague, Elad Gil, last week, when he mentioned that he has seen increase in vesting periods for startup stock.

It’s not necessarily surprising. Though at the end of the day, it doesn’t matter much. I’ll explain:

Why Does Vesting Exist?

The point of stock-based compensation is to align risks and rewards for all company stakeholders — investors, founders, managers, and employees. This way, all interested parties have a share in the upside of the company as well as the downside.

At each financing round (and sometimes in between), founders and investors will negotiate the size of the option pool, usually ranging anywhere between 10–20% depending on who they anticipate hiring. Founders negotiate the vesting on their own shares with their investors, and how they spend down that pool as they grant options to purchase shares to company employees or service providers.

Vesting the stock over a period of time provides the opportunity to motivate the team and manage poorly performing hires, all while optimizing dilution for founders. The “traditional” 4-year vesting period is a holdover from the 1990s when the average time to exit tended to be 4 to 5 years. (Pre-1990s vesting periods had been longer, reflecting longer times to exit.) Today, though vesting periods have stayed the same, time to exit has increased to 6 to 8 years or even longer, as larger amounts of capital have become available in the private markets and more companies choose to stay private longer. Vesting periods, however, haven’t quite caught up.

What Does A Longer Vesting Period Mean?

My initial reaction was that extending the vesting period would hurt recruiting. I was making the assumption that the grant would be the same number of shares, spread over a longer time period. In this case, founders are trying to lock up employees for a longer period of time and minimize dilution — quite an uncompelling proposition for prospective hires!

But what if my assumption was incorrect? What if a 6-year grant had, at minimum, 150% of the shares of the 4-year grant? In that case there would be a slight benefit to prospective employees from getting all the shares at a lower strike price, assuming the company is successful over the next 6 years and the stock price goes up. But this isn’t great for founders; granting more shares upfront would require a larger normal pool, potentially resulting in more upfront dilution than necessary. So no one gets a particularly good deal in this scenario.

Of course you can’t examine the grants or the vesting period in a vacuum. A seemingly great offer with a shorter vesting period from a less inspiring company may not be as lucrative as a less attractive offer with a longer vesting period from a more interesting company. Also keep in mind that most company exits are acquisitions versus public offerings, which means there’s a high likelihood vesting periods will be adjusted as the parties negotiate founder and employee retention plans.

A Better Question

Reviewing the rationale for stock-based compensation, the real question is: how do you keep employees motivated, highly performing, and aligned with other company stakeholders?

Whatever you do, you need a compensation philosophy that is clear, consistent, and effective:

• Clear. It’s easy to explain and to implement. If you’re a founder, are you eager to explain it, or defensive when asked? Prospective hires, does it make sense to you, intellectually and emotionally?
• Consistent. It’s consistent with company culture and consistently applied. In a previous post, I’ve talked about the importance of following through on stated culture principles. Compensation — a significant component of culture — is no exception.
• Effective. The program can scale as the company grows, keeps good performers feeling appreciated, and gives founders comfort in their ability to manage downside risk of dilution or low performers. Andy Rachleff has described a solid compensation philosophy framework, calling for a mix of promotion-, tenure-, and performance-based grants in addition to the initial one.

Parting Words

Companies need to examine their vesting periods in the context of their compensation philosophy — and in the context of the culture they want to create. As the startup market cools for some, and a new crop of tech recession-ready companies dig in their heels for the long haul, we can expect to see some startups experimenting with compensation across all vectors to reflect the companies they are, and the companies they want to be.

Thanks also to Brett May for his input here.

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Originally published at karenroterdavis.com on March 22, 2016.