What are current (2016) best practices for employee stock option programs for US pre-IPO startups?

Question: (org. on Quora)

Answer (by Dan Walter)

Hi Alex.  Thanks for the A2a.  And thanks to Shriram Bhashyam for also recommending me.
The first thing to clarify is the difference between “best practices” and most common practices. In the realm of equity compensation the most common practices are seldom the best. I will try and cover a bit of both.
“Early Stage” has also become a term of art in many cases. In this case I will write from the perspective of a company who may have up to a medium sized B Round. Your company may certainly fall into a different category.
Lastly, before I get into details, please realize that essential ANY equity compensation data is wrong at some fundamental level. Since you are unlikely to know how another company has designed their plan, what their investors expectations are, what the releasing timeline and potential value at the time of liquidity and whether the liquidity event is focused on IPO or acquisition (*and a series of other potential factors), you may be comparing apples to hotdogs, or plastic cups. (A list of the 11 reasons your equity compensation data is wrong)
The most common practices in the Silicon Valley (another assumption I am making, since these rules may not apply to you if you are located elsewhere) have been generally boxed in by VCs over the past couple of decades. The VC sway on startups is so strong that many companies (and many VCs) don’t realize that there may be other ways.  In summary:

Continue reading

If a start-up terminated an employee, is it required to allow them to exercise the relative portion of their stock option grant that is yet vested?

Question: (org. on Quora)

Answer (by Dan Walter)

This is a fairly common question. The short answer is no. But, it depends.
The first thing you should turn to is your grant agreement.  This will explain things like vesting schedules (generally when you can beging exercising stock options, or when you gain access to the stock or cash underlying things like. RSUs.  The vesting schedules may also require that a change in control or IPO take place before any vesting is finalized.
Your agreement is also the most common place to see the details on post-termination grace periods.  This is what may allow you to exercise any vested amounts after you  leave. The rules for these are usually different depending on the type of termination.  Example:  Death or Permanent Disability may give you 6 months or a year, termination without cause may give you 30 days or three months, but being fired or “terminated for cause” often results in an immediate forfeiture of anything vested.  Anything unvested usually is cancelled the date of termination, regardless of the reason.
If your vesting schedule allows exercises and your termination grace period allows exercises, they may still be additional restrictions that would keep you from exercising.  Some of these may be defined in your agreement.  Others may be found in the plan document.
You need to ask the company to put in writing their reasons for not allowing you to exercise.  And you need to do this quickly.  If there is a grace period you don;t want to mess around with the grant after that expires.  If the company is on the edge of a transaction like an acquisition, you don;t want to have to learn a new set of people and rules.

Equity Compensation Triage Assessment (Stock Options on Precipice Part 2)

6a0134836082f8970c01b7c8140d49970b-200wiThe first article in this “Stock Options on the Precipice” series covered some of the main issues that are currently impacting employee stock options (check it out here). This article will discuss some of the paths you might take if you are having stock option concerns. For many executives, human resources and compensation professionals, this may be the first time to experience the trials and tribulations of stock options. For others, the questions below and the assessment process may be a new way of addressing this issue.

Luckily, Continue reading

How have you seen Stock Options or Performance Rights grants change for employees from Pre-IPO to Post-IPO?

Question (Orig. on Quora):

How have you seen Stock Options or Performance Rights grants change for employees from Pre-IPO to Post-IPO? What are the triggers and how have the amounts differed? Building out our long term comp strategy. Thanks!

Answer (by Dan Walter):

First, it must be clarified that this answer refers to “pre-IPO” as companies with a realistic chance of an IPO, not simply any company (tech or not) that is not currently publicly traded.  This distinction is important since it plays directly into many of the design goals and trends for equity compensation. I can cover non-pre-IPO companies in a separate post)

Second, the difference between pre-IPO companies and so-called “unicorn” (>$1B) pre-IPO companies is also a significant differentiator in equity plan design and use.

Stock Options:
For most pre-IPO companies these are fairly basic. MOST TYPICAL… They may be ISO or NQSO. They are granted with a strike price equal to the IRC 409A) compliant Fair Market Value of the companies common stock.  They vest over time. Usually over 4 years. Sometimes 25% each year, sometimes 25% at the end of the first year and monthly for 36 months after that. We are also seeing more grants with a secondary event-based goal that has to be met before final vesting takes place (typically Change in Control). Leaving the service of the company usually ends up with the individual losing all unvested options and having a limited period to exercise vested options (usually 3 months for termination in good standing, 0 for cause, 1 year for death or disability). Grant size is generally determined as a % of outstanding shares for early employees and some formulaic number of shares for later employees. Exercises, if allowed before the IPO, usually require cash paid directly by the optionee to the company. The optionee is no longer an employee the cash payment may also include taxes due (since withholding may be difficult or impossible).  In a small percentage of companies still optionees are allowed to exercise unvested optionees and hold the remaining shares until they are vested.

So what is different for post-IPO options?
Often not much. The grant price becomes driven by the stock price traded on the open market (usually closing price on the date of grant). Vesting is generally the same schedule as pre-IPO (although many companies do away with allowing exercise of unvested options). Vesting for post-IPO seldom requires any trigger other than time. Leaving the service still ends up with the option losing unvested options and having a limited time to exercise vested options. GRANT SIZE: once a company is public grant size is most commonly driven at least partially by the black scholes value of the options at the time of grant. Values are less likely to be based on percentages or fixed formals and more likely to be based on compensation dollar values. Exercises become much easier with the addition of same-day sales and net settlement methods for payment. But, with public trading comes insider trading policies, black-out windows and, for some officers, SEC filings for nearly every transaction.

Back to pre-IPO companies
But, companies that stay private for a long time AND have a lot of employees AND grant a lot of equity may find themselves running out of stock options to grant.  This is one of the two biggest drivers for the pre-IPO move to Restricted Stock Units (RSUs). The other major driver is the fact that most options allow for a voluntary exercise transaction. These transactions create shareholders.  Too many shareholders means the company must file information with the SEC that may be available to competitors.  So, companies move to RSUs and restrict the vesting event to occur only after a period of time (usually at least 3 years) AND after the company choose to file publicly.  This can simplify the process for the company, but removes a lot of flexibility and leverage for the individual.  But, it still beats giving no equity at all.

More recently companies have been granting RSUs with performance-based vesting (most often also requiring a period of time to pass as well, typically at least a year).  Performance criteria for these pre-IPO performance-based RSUs are usually focused on internal financial and operational metrics.  Companies love metrics like EBITDA, but we recommend metrics that are more closely aligned with the jobs people do and decisions they make, rather than something like EBITDA that is a result of many things, but may not be understood or feel like it can be personally impacted by individuals.

Performance equity is still relatively uncommon in pre-IPO companies, except officers, but it is a growing trend.

So what about Public companies?
Public companies who moved to RSUs pre-IPO usually stick with them after the IPO.  Most of these companies also add and ESPP (Employee Stock Purchase Plan) that is focused on the rank and file.

At the time of IPO most companies create entirely new plans that are built to conform with public companies rules and best practices.  These plans also can include an “evergreen provision that automatically increases the pool of shares available to grant on an annual basis. Evergreen provisions usually expire before the start of the 4th fiscal year after IPO (shareholders and the advisors kind of hate them).

It should also be noted that overhang changes pre and post-IPO.  This is partly due to the different ways overhang is calculated pre and post-IPO.  But it is also due to the fact that once a company goes public people start exercising options and RSUs start vesting.  Every exercise of options or release of vested RSUs moves equity from one side of the overhang calculation (outstanding equity) to the other (outstanding shares). SO, the impact of exercises and releases is double that of equity cancelled for a terminated employee which only impact the outstanding equity side of the equation.  The quick movement in transaction during the first year after IPO reduces overhang quickly at many companies, giving them more room for new grants (as long as they have new shares coming through something like an evergreen provision.)

Now if you have gotten this far you are probably taking this seriously.  So you should know a little secret.  While all of the above is true it doesn’t mean that it is right.

The most common methods of using equity compensation are often not supported by any evidence of effectiveness. They are follow-the-leader approaches that many lawyers and compensation consultants throw out to companies to create average solutions (and great consulting fees).

The real process to determine a long-term compensation strategy requires a true understanding of your company culture and strategy. It requires know how and why each equity instrument works and it requires a communication program that ensures that your employees perceive the value of equity in a manner similar to your intent for that equity. The end result is a program that is unique to your specific facts, circumstances and goals.

I can go on (I have co-authored books on this topic), but I will wait for any follow-up questions first.

I’m leaving a startup. How much co-founder equity should I get?

Question: (org. on Quora)

As a grad student, I worked 5M part-time (25% of total time) with a co-founder, who came up with, funded and executed the idea. We were supposed to split 50/50 if I become full-time. However, we missed a  milestone & I’m leaving to look for a full-time job. We never had a formal discussion with a contract, details on vesting schedule, etc.
I want to be compensated in equity for the work I put in. How much equity should I ask? What % equity is fair?

Answer (by Dan Walter)

culture. Learn more at www.performensation.com. My expertise includes equity compensation programs.

Would you or would you not exercise your stock options in this scenario?

Question details (original on Quora)

  • My strike price is $650, and the current fair market value is $1250
  • I must exercise my stock within 3 months from when I leave the company next week
  • The company won’t tell me how many shares are outstanding
  • The company is likely to go public (let’s say 70% probability) in the next 1-2 years at ~$10B IPO. I’d say the likelihood of an acquisition is pretty low.
  • Exercising all of my stock options would be a significant investment compared to my current savings, but if I were convinced this is a smart risk to take, I’d go all in
  • My stock does not meet the minimum requirements on secondary markets like Sharespost, so I’d only get a return at IPO or acquisition

Basically my question is: how do I calculate the expected return of my stock?

Answer, by Dan Walter

This is a more nuanced question than many people may imagine. There are certain things that truly are important to know before you make this decision.

1. Shares outstanding. While others have said this is not important, it is actually critical. Currently companies in strong IPO tend to have an IPO price of between $15 and $18 per share. Given your strike price the company likely has far fewer outstanding shares than it will have at the time of IPO.  This is probably a good thing. You will likely end up with far more shares after the split (lower price = more shares since total value won’t really change).  To get to a price of $17 given todays price of $1250 you would have to multiply the outstanding shares by about 73.5 times.  Since we have no idea how “accurate” the current value is, it would be hard to provide great advice on this point.

2. Rules regarding your grant.  Can the company buy back your VESTED and EXERCISED shares?  If so, at what price?  While this is not common, it has happened at some high profile companies over the past decade.  You may find yourself spending your money, then simply getting back in a couple of years.  You may have to write off losses and deal with the lost time-value of your money.  Without fully understanding your plan details, it is hard to know how this will work.

3. You haven’t mentioned whether you have ISO or NQSO stock options.  If you have ISOs then you won’t be paying taxes at the time of exercise, but there may be an issue with AMT if something great happens with the company before the end of the year.  With NQSOs the spread (right now $600 per share) will be taxed as ordinary income.  This will be paid at the time of exercise, and likely via withholding by the company.  They may allow you to have some of your vested shares withhold to cover the taxes, but more likely they will require you to add around 40% to the total exercise cost.

4. An IPO two years out is unlikely to be a 70% probability.  There are, of course, exceptions to this rule of thumb, but if the IPO is planned and being worked on for execution within the next 12 months, I would lower your expectations.  A lot can happen in 2 years…

And with all of that being said… You have options that are already almost 50% in the money.  It sounds like you have enough of them to make the exercise a burden, but perhaps not a life changing risk. If you had 500 stock options exercisable you would be looking at an exercise cost of $325,000, plus taxes due (assuming an NQSO) of around $120,000, having a value of $625,000.  So a net value at the time of exercise of $205,000.  Of course we have no real idea of the potential future vaue since we have no idea of the current company value. A $10B value in two years won’t mean much if today’s value is $7.5B.

I hope this gives you some good information to ask the company some specific questions.

When is it smart for salesforce compensation to include stock options?

Answer by Dan Walter (original question on Quora)

Great question, and one that is getting more attention lately as more sales forces are evolving from selling things with a quick hit of revenue, to selling services with long tail of revenue.

Traditionally sales people have been viewed as “coin-operated”. This has meant they sell something, the company gets paid fairly quickly and the sales person gets their share.  There may have traditionally been a long-term component, but it was small… relative to annual, or even shorter, incentives.

Evolving to an “annuitized sales model” requires taking a new look at sales compensation. A $100,000 sales that will be paid over 5 years requires a different pay program than a $25,000 sales that is paid this quarter.

Stock options and other forms of equity compensation are designed as mid-term and long-term incentives and retention devices.

  • Do you sales processes take a very long time?  Think in terms of years, not months.  If so, stock options may be a good tool.
  • Does your sales process include selling a small level of services today with the goal of building the level of services over a long period of time?  If so, stock options may be a good solution.
  • Does a sale at your company take months or years to get fully paid (ex. 3 years contract paid in equal monthly installments)?  Stock options may also work in this scenario.
  • Are your “sales people” really some hybrid of marketing, relationship manager and sales pro? If so stock options might make sense.
  • Are your sales people also professional services people.  Essentially consultants who are “rainmakers”?  This can be a great time to use stock options.
  • Are your sales people selling “stuff”? And, are they paid a good commission on that stuff, based on some level of profit margin to ensure the company also gets its share?  This may NOT be a great place to use stock options, unless it is a bigger piece of your culture and compensation philosophy and used as a form of communication to tie everyone to common goals.

Figure out where you are (or where you want to be) relative to the information above.  Then take a look at the answer provided by Jason Lemkin in this thread as it also has some important considerations.

There is a start-up that has $5MM in revenues that wants me as an advisor to get them to $500MM. How much equity should I ask for?

Additional Question details (orig. on Quora):

CEO was only getting 3-5%. If that is the case, I can’t imagine they would give an advisor more than 1% which seems low.

Dan Walter’s Answer

I think that it is impossible to answer this question without far more information. This is a common issue that start-ups must address and it is often done without enough forethought. Here are just a few questions.

Michael Wolfe’s answer of 0.1% may be perfect. Brian Schuster may also be right at 3%.

This huge discrepancy is easily explained by not knowing the underlying details.

What will be your part in getting the company to $500MM?  Is all $450 increase dependent on your actions? Your ideas? Is there a reasonable percentage of the gain that will be able to be demonstrably attributable to you?

Will this role be full time? Are there already multiple rounds of financing in place?  Given that the CEO only has 3-5% I am assuming he/she is not a founder.  If they are, then they probably have at least 5 rounds of financing in place (which seem pretty high for a $5M company.)

What is the likelihood of actually attaining $500M? How long will it take? Does this value include any the value of any potential future acquisitions or mergers (and their associated costs / dilution)?

I am sure their are tons of experts on Quora who can each add at least as many questions as I have in this quick post.
If the potential is 3% of $500M ($15M), it pays to do the groundwork in advance.  If the potential is only 0.1% of $500M ($500K) then it pays to set limits on your effort.

What is the difference between restricted stock vs. restricted stock units?

Question: Orig on Quora)

The only difference I can find is that with restrictive stock the employee technically owns it upon granting and can do a 83-b.  Also restrictive stock dilutes the company at granting.  Restrictive stock units will dilute when they vest and the employee can not do a 83-b upon granting.

Answer from Dan Walter

This is a great question.
High level Summary.  For Restricted stock awards shares are issued as of the award date, making people immediate shareholders (voting and dividends etc.). For RSUs the shares are issued only after vested (no voting until vested, no real dividends, only the possibility of dividend equivalents.)

Restricted Stock (RSS)

Restricted Stock Units  (RSU

  • Much easier to link to performance goals than RSS
  • Much easier (mechanically) to take back from participants if they leave the company
  • When designed correctly allow the possibility of the participant electing to defer their full rights to the stock until a later date (great if you already have a lot of money)
  • Easier to settle in cash
  • When vesting occurs, may be FAR less dilutive since it is possible to issue only the Net shares (full vesting less amount equal to Taxes owed)

Detailed answers can be found in the following two posts.  (It didn’t seem to make sense to rewrite these)
Restricted Stock: Equity Compensation – Restricted Stock Shares, Always a Great Tool, Sometimes
RSU:  Equity Compensation – Restricted Stock Units (RSUs), Downside Protection with a Couple Downsides

What are the salaries and benefits for early stage employees in a startup, such as the first ten hires?

Question: I am writing my business plan now and I want to do some analysis on what other startups in Silicon Valley or other cities in the USA offer. Thanks! (see orig,. post on Quora)

Answer by Dan Walter

I work with a ton of early-stage companies.  This is a “Top 5 Question” for nearly all of them but the answer can be a bit murky

Industry is a huge driver.  Since this is Quora I am going to assume you looking for info on Tech start-ups, but even that may be too broad.
Location is likely to be just as big a driver.  A tech firm in the Midwest, will generally not effectively pay in the same way (or the same amounts) as a tech firm in the Silicon Valley.
Funding is also a big player.  Bootstrapped? Looking for Angel / VC in the short term? Your source of initial funding will likely drive the type and levels of pay far more than you would expect.  For example.  Many VC firms have a basic “formula” they use for nearly all of their clients.  They have preferred types of equity, preferred sources for compensation data and preferred percentages to be set aside for equity, bonuses, etc.
Most importantly, if you can navigate that other stuff, is to determine who you will be competing with for talent, and how you can clearly communicate what makes you better (not just different.)
To answer your actual question: “What are the salaries and benefits for the first ten hires”.  Salaries, will be as little as possible while still brining in the best talent.
“Best” is a relative term.  Your first ten hires are likely to be the foundation of any success your company will EVER have.  They will establish levels of excellence, work habits, general work culture and far more. In today’s tight labor market these people will likely need to get paid close to the same amounts as public companies. Any salary will be augmented, or replaced by equity compensation. This is most likely to be in the form of stock options, is always not be the best choice for every company.
If you are hiring tech veterans who have already earned a few (or more) million, you may be able to get away with far less up front cash, in return for offering better equity compensation packages.  This is a cheap way to get moving, but can be a very expensive method if you take the average 7-10 years to real liquidity.
If you are hiring recent college grads/drop outs you may be able to get away with paying less, but you take several big risks. 1. Not a proven work force in many cases. 2. May be striving for somewhere else from the day they start.  May require far more management and guidance, which can cost far more than money.  BUT, you may also get potential upsides. 1. May be the “next great [insert name here] and what you get from them will exceed anything you will ever pay them. 2. You can “build” the work environment, culture etc. you want, rather than import it from veteran employees’ past experiences. 3. They usually require less in living expenses as they are less likely to have kids, houses etc.  That being said, great talent will get hired away if you can’t or won’t pay them what they need or want.
DON’T give too much credence to Salary dot com or  GlassDoor compensation levels.  When comparing these against more robust industry survey data it is clear that many “self-reporters” provide “aspirational” numbers to these services.  Compensation survey data exists, from many sources, but is still not perfect for the first 10 people.
Using a PEO (like Trinet or Accretive Solutions) can give you better benefits at lower costs.  They often have customer groups will may be willing to share information about compensation levels.
Lastly, be economical, but don’t be cheap. You do not employees who are the equivalent of a Black Friday $59 TV. They will seem great for a few weeks, but the missing functionality and lack of quality will become apparent, then annoying, then frustrating, then simply terrible in short order.