Startup Equity: Isn’t It Refreshing? (maybe not) – (Part 6 of an n part series)

untitledThe historically long periods between the startup and “big event” for companies has given rise to many issues that were never considered when stock options and other equity tools first became the preferred startup incentive tool. Among these unplanned issues are things like:

  • Wealth inequality between the first 20 employees and employee 5,000 or 12,000 or more
  • Grants expire when the company has not yet made its move to IPO
  • 409A Valuations
  • Dilution and burn rate issues long before IPO
  • Grants becoming stale
  • Downward movement in stock prices
  • (Ugh, this list can take the maximum 800 words allowed for this post)

This post we will discuss the controversial issue of “refreshing” grants for long-term employees. To clarify, these are not grants for promotions or company-wide performance. These are equity compensation awards that are given simply because someone has been around a while and there is a feeling that they need a “bit more” or a “reminder” to help keep them focused. Refreshing equity isn’t a bad idea, but it may not be practical or useful for every startup.

FORMULAS DO NOT WORK

Hmm. That was a random statement. Back to the post.

Public companies refresh grants as a standard practice. All the following factors and more play into public companies granting new equity to old employees.

  1. Their stock prices are more volatile, more frequently than startup prices.
  2. The ability for individuals to sell their shares means that old grants lose their power (since they no longer exist).
  3. If the stock price is rising, equity plan overhang goes down as people exercise stock options, or have RSUs vest. This moves the awards out of the “potential dilution” column.
  4. Public companies tend to hire less mercurially than startups. Staff increases are budgeted and planned in advance. Execution is a matter of finding people and applying a relatively consistent compensation philosophy to their awards.

Startups have very few of these issues but have other problems that can make refreshing equity difficult.

  1. As a rule, startup values generally go up. When they go down, the last thing investors want to talk about is more dilution.
  2. Since there is no real market for private shares, peoples’ equity awards tend to remain fairly static while prices rise around them. Value goes up without new awards taking place.
  3. Overhang at startups goes up. It only goes down when people with significant grants are terminated (and they don’t exercise prior). The more equity you grant, the grumpier your investors get.
  4. Startups hire in fits and starts. You hold back as long as possible. When funding comes in you, scramble to turn money into talent and products as quickly as possible. One year you may double in size, the next year may not hire anyone at all.

Over the past several years many people have touted their “answer” to the question of equity. Many of these answers include refreshing equity based on some formula (oh…that’s where that random statement came from.) None of these programs can work equally well for companies of any size, growth rate, funding and exit goals. In fact, most of them barely work for the company that invented them.

When you tell someone that every 2.5 years you need to give employees a new grant that is 25% of the size of their previous grant (that still has 1.5 years vesting remaining), it sounds like a reasonable plan. When you model this out for your company of 25 people over the next few years, it also seems reasonable. Reality hits when your employee growth rate is far faster, or the value of your company is far higher than imagined, or your event horizon is still not on the horizon, or your exit event has turned into a “not yet” event. You probably can’t pay pony up enough stock on the 2.5-year trigger date if you are also in the process of a huge hiring campaign. Your investors may rebel.

You can’t give people a block of new shares every time their old shares vest or are exercised. The lack of unvested equity may not be your biggest compensation problem. The vested or exercised equity may already have more value than you ever thought that person would earn. An IPO or acquisition may be looming eminently. Perhaps your initial grant size was far higher than it needed to be. Maybe the individual just received a large promotion grant. The possibilities are nearly endless and do not require “alternate reality” considerations.

Now, maybe your philosophy is to grant smaller than market grants upon hire date and reevaluate the performance of the individual and the value of the grant after a year or two. Refresh grants may work well.

Perhaps you are in the last year of an initiative that will fundamentally make your company successful. And, perhaps that effort is not so much about more employees as it is about motivating and focusing the minds and bodies who are already working with you. Refresh grants may make great sense.

Perhaps you have been around a long time and old grants are about to expire. Maybe these individuals have been doing a great job, but it is simply taking longer than planned to get to the finish line. Refresh grants are probably required.

Refreshing equity for the sake of refreshing equity isn’t great. Equity is both ownership and money. There isn’t an unlimited supply of either. Before your say, “we always (or never) refresh grants,” make sure you understand what could reasonably cause a change in the policy. Then be proactive in the face of changes. If equity were super-easy, everyone would get it right more often.

Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and has been deeply involved in equity compensation for a long, long time. Dan has written several industry resources including the recent Performance-Based Equity Compensation. He has co-authored ”Everything You Do In Compensation is Communication”, “The Decision Makers Guide to Equity Compensation”, “Equity Alternatives” and other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.