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.
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.