Stock options are a great way to reward employees in a startup/scaleup but there are many different ways to structure option agreements. I have strong views on the subject – mainly learned by making costly mistakes – but I been very fortunate to have had several successful exits which involved a significant option element.
To lay my cards firmly on the table: I’m an advocate of non-vesting employee share options (clarified below). These options reward the exact things we want in a startup/scaleup for ourselves and our colleagues: a desire to stick together, to create some significant value and to share in it fairly.
I’m often challenged to defend my views by people who say non-vesting options are “unfair” and constitute “abuse” of the employee relationship. I very strongly disagree and, based on my experience, I’d say they are actually much fairer – as I’ll explain.
Non-Vesting: If you Leave – you Lose
What I advocate is simplicity and the key terms of the option agreement are:
- Options can only be exercised in the case of a change of control (I call this “non-vesting” but perhaps it is more technically correct to say that they only vest and can only be exercised at that time).
- If you leave you automatically lose the options.
- The company retains the right to amend one or more of the above terms. So, in special cases, the company can use its discretion at the point someone is leaving and amend one or both terms for any or all of the options the employee holds.
In my view a majority (why not 100%?) of employees in a business should be offered these share options. In Actix (my own business), everyone had at least some share options and (at exit) that made up around 25% of the total (and at that time at least 10 people had options worth more than $1m so they were well rewarded for their hard work).
Holding options is about being part of the team. All aligned. Working together to make the company a success – today – tomorrow. It is not about the past – that is territory for founders and investors and it is littered with legacy problems in almost all real companies.
Non-vesting options become most valuable in the tough times – which almost all businesses will go through at some stage of their development. When backs are against the wall (there is no chance of a bonus this year, salaries are frozen – despite being low already) and everyone needs to pull together. In this scenario the last thing you want is a couple of key people having a chat and saying – what the hell – our options are vested – let’s leave and join a company that isn’t struggling – or even start one of our own and compete!
If options have vested then the desire to stick with the company through the tough times is gone.
Some people like to call share options an “employee retention mechanism” but I don’t really like that moniker. It’s sounds like HR-speak to me when, in reality, everyone benefits from sticking together in this way – not just the company but the other employees too. It is just no fun (and not fair) working hard on a lower salary to make your options valuable if your colleague just left for a better salaried job and will get the same return from a successful exit as you will because she is “vested”.
Vesting Schedules are a Problem
I’m really not sure why the people who advocate vesting schedules are so certain they are right. Many of them recognise that the vesting approach creates significant challenges, including Sam Altman of Y Combinator fame who states his views here. I agree with quite a bit of what Sam Altman says there, but his proposed solution: to extend the vesting period to 6 or more years – seems beg the question “why not get rid of the vesting schedule altogether?”.
It seems the idea of vesting is too ingrained in “start-up-think” to be properly challenged.
Non-vesting Simplifies Many Things
Removing the vesting schedule simplifies many things including:
- Voting rights. Pretty much everyone agrees that employee options shouldn’t result in ex-employees holding voting stock. This can cause a lot of complexity if options vest and employees then leave. If you have non-vesting options then it doesn’t matter whether the options are granted over voting stock or not because they will never actually hold the shares.
- Share register bloat. It is not great to have a large number of small shareholders on a share register – even if they have non-voting shares. It creates administrative problems and results in a lot of extra legal expense. If options are non-vesting then the share register remains (relatively) clean.
- Subsequent option issues. In many companies options will be “topped-up” on an annual basis. If the options vest then it can become very onerous to track what options each employee holds and their status. If the don’t vest then the situation is much simpler.
- Finding the money for the employee to acquire the vested options when they leave. This is a massive pain and costs a disproportionate amount in management time and fees. If options don’t vest this problem goes away altogether.
- International tax regulations. You might only have employees in one country now but most successful companies will have to expand internationally. In all tax systems where employees of companies I’ve worked with hold options (and that’s a lot of countries! – at least 50) there is no problem with this non-vesting approach. It is also much, much simpler than working out how to enable an employee to exercise his vested options in a country where you may not even have a tax advisor.
Value is Not Created Linearly
I think a couple of other things seem to be said to clarify:
- Founders (and early stage investors it seems) are overly optimistic about how long it will take and how hard it will be to create and exit a valuable business. I still regularly hear people talking about a 3-5 year journey. Why do people still believe that – despite all evidence to the contrary? In reality it will take 7-15 years for the successful ones to achieve an exit valuation their founders are happy with (barring edge cases that are statistically irrelevant – but which everyone talks about).
- At the early stages of a business people don’t tend to foresee (and therefore don’t take into account) events which turn out to be very common, such as: changes of direction (pivots) and fluctuating business fortunes (ups and downs in trade). In the real world value is not created linearly. It does not follow that a business on a good growth path today will continue on that path without twists and turns in the road.
- The number of options issued to early employees will be higher, percentage wise, than the number issued to later stage people. Arguably this, in itself, can be considered unfair because, for a similar level of role in a later stage business, there will be more responsibility and, potentially, harder work. The only way to make this disproportionately higher number of options fair is if everyone sticks with the company until the exit.
If value creation was a linear process based purely on work expended then someone who worked for the business for four years at the start as a project manager should have the same share in the exit proceeds as someone who worked for four years at the end in the same job. But value creation isn’t linear. It isn’t formulaic and it isn’t predictable. And company fortunes can go up and down. Companies can change direction – even larger ones – and the work done before such a change – when the business was floundering – is not of the same value as the work done afterwards. If you don’t believe in this then I guess you don’t believe in capitalism and the survival of the fittest.
Consider an example from my past, the case of a company in which the first CTO is given 15% with four year vesting. The company runs for three years and is doing OK but not great. They work on a couple of product ideas that are firmly in the comfort zone of the CTO but neither sticks. The CEO and board identifies an opportunity that is outside the CTO’s comfort zone and pivots the company in that direction. The CTO decides that it is time to leave – and 3/4 of his options have vested. He doesn’t have the money to exercise the options but comes up with a number of friends and family who put up the money in return for small chunks of the equity – because it seems “cheap” – and the options were transferable (the normal case) so this is OK. The company is left without a CTO, with a group of small shareholders it didn’t really want, and has to undergo a further 10% dilution of investors and founders to attract another CTO. All before the first product of the new generation is even built. Is this fair?
Another example is from my own business, Actix. It took 15 years to build the company to a $100m+ exit. Around 350 people were employed at some point in the journey and, of those, around 250 were with the business at exit. These 250 shared in the exit proceeds – the other 100 didn’t. I think that was right and fair. People knew all along what the terms of the options were and I had absolutely no dissent from anyone about them. Other businesses in the industry had much higher staff turnover and I suspect this was partly because of the non-vesting option scheme. But it was also because we were a great team that stuck together and worked hard for the end goal – I’d like to think a lot of people would have done that whether they had options or not – but it was also great to get the payback!
Compensation and Recycling Options
I think options can help to make up for lower salaries in startups – but only if they don’t vest. Options can be an incentive to lure talent to a startup and keep salaries in the company in check – which gives the company more runway and a better chance of success. But if the options vest then the incentive to keep a check on salaries is gone. This actually creates unfairness because some people doing a particular job might have fully-vested options while others don’t – so the ones with fully-vested options will probably expect, and get, higher salaries – again, is that fair?
Options are just one of the many elements of employee compensation – others being: salary, working conditions, startup culture, doing something exciting, being part of a great team, cash bonuses and other perks, etc. It doesn’t make sense to try to use options for something they aren’t fit for.
Options which are recovered from departing employees result in un-dilution (concentration I guess?) and this benefits everyone in the business who stays with the team. They can also be used to hire even stronger replacements (assuming the business is progressing) for the exact people who are leaving – resulting in the business having more chance of success – rather than simply being wounded by the loss of the early employee.
I also dispute the assertion that vesting is “fair” and businesses who don’t have a vesting schedule for their options are being “unfair” to their employees. Fairness is not an absolute – it is a judgement – and it is always easier to assess in hindsight.
For instance: is it fairer that a guy who worked for a company for 4 years but left 10 years ago was given options in the early days when grants were larger and has more of a share in an exit than the guy who replaced him and has been with the business for the last 8 years when all the real value creation happened? And what would your opinion on this be if the “4 year guy” had been working for a direct competitor for the last 5 years?
Fairness is really about whether a company did what it said it would do. If you say from the outset that options are non-vesting then there is no unfairness in taking them away when people leave the business. And if the company decides to allow an employee to keep part or all of their options when they leave then you can do it with the benefit of hindsight. If the same people are running the company at that point then they will do the right thing – whatever that is.
Another question I am asked is: “So what if an employee is forced to leave, against their will, by some event or health issue?”
The answer is, as mentioned earlier, that the company can always use its discretion to modify the terms as it desires.
For instance: If a loyal employee is too sick to continue working then the company can decide to vest all their options immediately – and then either allow them to exercise the options and retain a stake or buy them back at some agreed rate which might benefit the sick employee more.
Or: if the company decides that an employee leaving because her/his partner has been offered a great job in another town or country is a reasonable case for using these powers then it can allow them to retain some or all options (they would probably have to convert them to shares in most countries).
And if the question comes: “What if the people making the decisions in the company at this point aren’t so nice and don’t see things so fairly?”
Then my answer is this: “You are going to have much bigger things to worry about than this if you sold your soul to a bunch of professional investors who don’t give a damn about your employees. And if you really had no choice then you should have created a change of control event at the point this shift took place and that would have triggered the options to become exercisable so people could make their own choices whether to stick around in the new regime”.
If you trust yourself to make good decisions about your employees now, when you have no idea of the twists and turns that your business will take, then why don’t you trust your future self to make good decisions too? Indeed your future self will be able to make much better decisions because you will have the benefit of hindsight. If you really want to allow an employee to keep his options at the point of leaving then you can make that decision. But the normal case will be that they lose them and that is fair for everyone.