The Lack of Options for (Startup Employees’) Options
Answer (by Dan Walter):
Scott’s answer is a great start to a discussion that has been needed for a long time. The lock step approach to equity compensation that is followed by most startups is not founded in any science, so it is right to question things.
But, extending the post termination exercise period to the full life of the grant is not sustainable. Most of the equity at startups is given the the first 20 (maybe 50) employees. This doesn’t leave much for any else to begin with. Without having the ability to recycle stock options (and other forms of equity compensation) companies would quickly end up with nothing to grant at all.
The accounting rules and lack of cash make it difficult, but not impossible, for the company to provide cash at the time someone leaves. It is also counterintuitive to give leavers money when those who stay cannot get money.
More successful (read profitable or very well funded) companies are looking at creating some type of market for employees and ex-employees to get out from under some of their equity. As these techniques mature I think we will see more companies extend the post termination exercise period to a length long enough to allow people to participate in the next private round of liquidity. This would probably be more fair and reduce the overhang that is a problem for any long-term pre-IPO company. It is a big problem even when the only people holding equity are employees.
I think you may also see growing use of options that have lives much shorter than ten years. These may be linked to cash incentive programs that are designed to drive exercise and hold transaction, once again reducing the burden on lower paid staff members.
Also, options were never meant to be a guarantee or direct replacement for cash. They were intended to be a reward for the commitment to the long-term success, while remaining a fairly inexpensive tool for companies. They were also designed to inspire long-term holding (hence the periods associated with Incentive Stock Options).
If a company plans to be successful with a relatively small number employees (let’s say less than 250) then long-term post-termination periods may be viable. If they company requires a larger staff, or a significant number of senior players, the “10 year exercise period” is likely to drive as many or more problems as the current vanilla solutions.
The key is this: Equity compensation is both very flexible and very complex. Companies tend to follow the leader because 1) Their lawyers like to follow plans that have already been tested in court, 2) Investors like to use plans that fit easily into their pre-made financial models, 3) Consultants often choose the easiest path to approval rather than the best path to success, 4) Companies can get a vanilla plan created much cheaper than a more “bespoke” plan that may work better, 5) Internal HR, Compensation and other related professionals seldom have deep expertise in the design elements of these programs and must therefore simply trust that those giving advice actually know what they’re talking about. There are, of course, additional reasons to follow the leader, but, like building a company, following the leader is seldom the best path to success.