How to Make Startup Stock Options a Better Deal for Employees

When a group of engineers launched Fairchild Semiconductors-the first chip startup in Silicon Valley-in 1957, investors offered the founders a relatively new type of compensation: stock options.

By the mid-1970’s, investors in venture-funded startups began to give stock options to all their employees. On its surface this was a pretty radical idea. The investors were giving away part of their ownership of the company-not just to the founders, but to all employees.

Why would they do that?

Stock options for all employees of startups served several purposes:

• Because startups didn’t have much cash and couldn’t compete with large companies in salary offers, stock options dangled in front of a potential employee were like offering a lottery ticket in exchange for a lower salary. Startup employees calculated that a) their hard work could change the odds and b) someday the stock options they were vesting might make them into millionaires.
• Investors bet that by offering prospective hires a stake in the company’s future growth-with a visible time horizon of a payoff-employees would act more like owners and work harder, and that would align employee interests with the investor interests. And the bet worked. It drove the relentless “do whatever it takes” culture of 20^th Century Silicon Valley. We slept under tables and pulled all-nighters to ship products and make quarterly revenue-all because it was “our” company.
• While founders had more stock than the other employees, they had the same type of stock options as the rest of the employees, and they only made money when everyone else did (though they made a lot more of it). Back then, when earlier angel and seed funding didn’t exist to get the company started, founders put a lot more on the line- going without a salary, mortgaging their homes, etc. This “we’re all in it together” kept founders and employees aligned on incentives.

Mechanically, a stock option was a simple idea – an employee received an option (an offer) to buy a part of the company via common stock options (called ISOs or NSOs) at a low price (the “strike price”). If the company was successful, the employee could sell the stock at a much higher price when the company listed its shares on a stock exchange (an “initial public offering”) or was acquired.

Employees didn’t get to own their stock options all at once. The stock trickled out over four years, as one would “vest” 1/48 ^th of the option grant each month. And just to make sure you stuck around, with most stock option plans, unless you stayed an entire year, you wouldn’t vest any stock.

All employees – founders, early employees (who received far fewer options than founders, but more than later hires), and later ones all had the same vesting deal, and no one made money on stock options until a “liquidity event.” The rationale was that since there was no way for investors to make money until then, neither should anyone else. Everyone-investors, founders, and startup employees-was in the same boat.

Therefore, the time until a liquidity event was crucial. In the 20 ^th century, the best companies IPO’d in six to eight years after startup; in the dot-com bubble of 1996-1999, that could be as short as 2-3 years. Of the four startups I worked at that went public, it took as long as six years and as short as three.

How Startup Compensation Changed

Much has changed about the economics of startups in the last two decades. And Mark Suster of Upfront Capital has a great post that summarizes these changes.

The first big idea is that unlike in the 20 ^th century when there were two phases of funding startups- Seed capital and Venture capital-today there is a new, third phase. It’s called Growth capital. Instead of a startup going public six to eight years after its founding to raise capital to grow the company, today companies can do $50 million-plus private raises at that point, deferring the need for an IPO to 10 years or more after launch.

The entire premise of growth capital is that by staying private longer, all the growth upside that used to go to public-market investors (Wall Street) could instead be made by the private investors (the VC’s and growth investors.)

The three examples Suster uses-Salesforce, Google and Amazon- show how much more valuable the companies were after their IPOs. Before these three went public, they weren’t unicorns – that is, their market cap was less than $ 1 billion. Twelve years later, Salesforce’s market cap was $18 billion, Google’s was $162 billion, and Amazon’s was $17 billion. To Suster’s point, it isn’t that startups today can’t raise money by going public; it’s that their investors can make more money by keeping them private and going public later – now 10-12 years. And currently there is an influx of capital to do that.

The emergence of growth capital, and pushing an IPO out a decade or more, has led to a dramatic shift in the balance of power between founders and investors. For three decades, from the mid-1970s to the early 2000s, the rules of the game were that a company must become profitable and hire a professional CEO before an IPO.

That made sense. Twentieth-century companies, competing in slower-moving markets, could thrive for long periods on a single innovation. If the VCs threw out the founder, the professional CEO who stepped in could grow a company without creating something new. In that environment, replacing a founder was the rational decision. But 21 ^st century companies face compressed technology cycles, which create the need for continuous innovation over a longer period of time. Who leads that process best? Often it is founders, whose creativity, comfort with disorder, and risk-taking are more valuable at a time when companies need to retain a startup culture even as they grow large.

With the observation that founders added value during the long runup in the growth stage, VCs began to cede compensation and board control to founders.

While founders in the 20 ^th century had more stock than the rest of their employees, they had the same type of stock options. Today, that’s not true. Rather, when a startup first forms, the founders grant themselves Restricted Stock Awards (RSAs) instead of common stock options. Essentially the company sells them the stock at zero cost.

In the 20 ^th century founders were taking a real risk on salary, betting their mortgage and future. Today that’s less true. Founders take a lot less risk, raise multimillion-dollar seed rounds, and have the ability to cash out way before a liquidity event.

Early employees take an equal risk that the company will crater, and they often work equally as hard. However, today founders own 30-50 times more than a startup’s early employees.

On top of the founder/early employee stock disparity, the VC’s have moved the liquidity goal posts but haven’t moved the vesting goal posts for non-founders. Consider that the median tenure for an employee in a startup is 2 years. By year three, 50% of the employees will be gone. If you’re an early employee, today the company may not go public until eight years after you vest.

So why should non-founding employees of startups care? You’ll still own your stock, and you can leave and join another startup. There are four problems:

• First, as the company raises more money, the value of your initial stock option grant gets diluted by the new money in. (VC’s typically have pro-rata rights to keep their percentage of ownership intact, but employees don’t.) So while the VCs gain the upside from keeping a startup private, employees get the downside.
• Second, when IPO’s no longer happen within the near-time horizon of an employee’s tenure, the original rationale of stock options has disappeared. Now there’s little financial reason to stay longer than the initial grant vesting.
• Third, as the fair market value of the stock rises (to what the growth investors are paying), the high exercise price isn’t attractive for hiring new employees, especially if they are concerned about having to leave and pay the high exercise price in order to keep the shares.
• And finally, in many high-valued startups, today’s founders get to sell parts of their vested shares at each round of funding. (At times this opportunity is offered to all employees in a “secondary” offering.)A “secondary” usually happens when the startup has achieved significant revenue or traction and is seen as a “leader” in their market space, on the way to an IPO or a major sale

VCs have intentionally changed the more than 50-year-old social contract with startup employees. At the same time, they may have removed one of the key incentives that made startups different from working in a large company.

While unique technology or market insight is one component of a successful startup, everyone agrees that attracting and retaining A+ talent differentiates the winners from the losers. In trying to keep companies private longer, but not pass any of that new value to the employees, the VC’s may be killing the golden goose.

What Should Employees Do?

In the past, founders and employees were aligned with the same type of common stock grant, and it was the VCs who got preferential stock treatment. Today, if you’re an employee, you’re at the bottom of the stock preference pile. The founders and very early employees have preferential stock treatment and the VCs have preferred stock. And you’re working just as hard. Add to that all the other known negatives of a startups: no work-life balance, insane hours, inexperienced management, risk of going out of business, etc.

That said, joining a startup still has a lot of benefits for employees who are looking to work with high-performance teams with little structure. Your impact will likely be felt. Constant learning opportunities, responsibility, and advancement are there for those who take it.

If you’re one of the early senior hires, there’s no downside of asking for the same Restricted Stock Agreements (RSAs) as the founders. And if you’re joining a larger startup, you may want to consider those offering restricted stock units (RSUs) rather than common stock.

What Should Investors Do?

One possibility is to replace early employee (first ~10 employees) stock options with the same Restricted Stock Agreements (RSAs) as the founders.

For later employees, offer what are called restricted stock units (RSUs). Restricted Stock Units are a company’s promise to give you shares of the company’s stock. Unlike a stock option, which always has a strike (purchase) price higher than $0, an RSU is an option with a $0 purchase price. The lower the strike price, the less you have to pay to own a share of company stock. Like stock options, RSU’s vest. But to keep employees engaged, they ought to be allowed buy their vested RSU stock and sell it every time the company raises a new round of funding.

Venture capital structures were set up for a world in which successful companies exited in six to eight years and didn’t raise too much capital. Today, venture capital growth funds are now giving startups the cash they would have received at an IPO. This has moved the need for an IPO out another five years, allowing VCs to capture the increase in market cap in the company. And the market cap at IPO time will exceed anything yet seen for startups.

Investors and founders have changed the model to their advantage, but no one has changed the model for employees. Moving the liquidity goal posts may have removed the incentive for non-founders to want to work in a startup versus a large company. Stock options with four-year vesting period are no longer a good match for employees when it may take 10 to 12 years for the company to go public or be acquired.

VCs need to consider a new stock incentive model – RSA’s for the first key hires and then RSU’s – Restricted Stock Units for everyone else.