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:

  • VC backed firms are usually looking at setting aside no more than 20% of outstanding shares for equity compensation. In many companies as much as half of this allocation is gone by the time the 20th employee is hired.
  • Early stage officers (if non-founders) generally get more than 0.5% and less than 2% of the company. Exceptions may include a truly unique individual with the experience or contacts to make a fairly quick and undeniably huge impact on the potential success of the company. (People with great potential and no track record seldom call into this category.)  The truth is that most executives, outside of the CEO (if he isn’t a founder) get between 0.8 and 1.4%.
  • In most cases 90-95% of the equity any individual will receive is in their initial grant.
  • Nearly everyone gets stock options. Early stage companies often still use Incentive Stock Options, but as often as not companies are using non-qualified stock options (a quora post on the difference).
  • Nearly everyone is 100% vested by the end of 4 years.  This may be in 25% annual increments or may be 25% at the end of the first year and the remainder vesting monthly or quarterly over the next three years. For early officers the allowance of exercise prior to vest (early exercise) is often included.
  • Most companies provide little or no financial information to optionees. For some unknown reason lawyers, consultants, executives and investors all assume that people already know a lot about these tools. (let’s just say that is not an accurate assumption.
  • Nearly all of the stock options have a ten year term. If they are not exercised by the tenth anniversary they expire and return to the plan (or dissolve into vapor).
  • If people leave the company they are given grace periods to exercise their vested options.  Usually death and disability get 6-12 months, most other termination reasons get between 30 days and 3 months (the maximum allowed under ISO rules without the options losing preferential tax treatment). If someone is terminated for cause vested and unvested usual expire immediately.
  • Grant price is generally determined pursuant to IRC 409A through the utilization of a third party valuation firm.
So that’s “MOST COMMON” but is often quite distance from “BEST PRACTICES.”
The above list is more heavily weighted to investor objectives than it is any individual company;s objectives. The commonality of use makes it easy for investors to understand the impact to themselves. It makes them sound smart and confident when discussing this with founders. It is also legally sound and has been proven to work many times in the past. But, sounding smart and being smart may not be the same thing. Legally sound is often just a laxy person;s “legally easy.” And, while you can be shown many cases of this basic structure working in the past, it is sort of like show a highlight reel of a batter at the end of the season.  You see home-runs and impressive extra base hits, but you seldom see a series of pop-outs and strikes outs.
Best practices require knowing what you are trying to accomplish and understanding WHY equity compensation can help get you there. Some of the most admired and successful start-ups have ignored what everyone else was doing and instead crafted their own path. In a market where talent is scarce and expensive having a program that can differentiate you to a key player can be the convincing factor in getting the person you want.
  • The percentage of your company allocated to equity compensation should take into consideration who will get equity. If the goal is to only grant at higher levels, 20% may be too much.  If the goal is to grant to everyone, and your company is expecting “everyone” to be a big number of people, 20% may not get you anywhere near the finish line.  But, allocating more than you need early on can be a detriment in some situations (especially for some investors and some debt issues.)
  • Rather than give an individual nearly all of the equity they will receive prior to IPO in a single grant, it may make more sense for a more gradual outlay of grants. This can be like giving someone a side of beef and telling them that it is a 5 years of steaks. You may find that people would be happier with a better quality, fresh steak made to order than they are with a 5 year old hunk of frozen beef in the freezer.
  • The amount of equity you give should take into consideration the potential value at liquidity (be brutally honest on this.) Giving someone 1% of a company that is expected to be worth $20B in ten years is far different than giving someone the same percentage of a company that has a maximum potential value of $200M in 7 or 8 years. It seems obvious, but trust me….it isn’t.
  • Perhaps stock options are a good idea, but more and more companies are looking into RSUs as a component of equity. Stock Appreciation Rights may also make sense, especially for lower level employees.  And, if you start out as an LLC, you won’t have any stock and you will need to follow a completely separate path.
  • The four year vesting schedule became standard a very long time ago (like the late 1980’s!). It is a relic of a time when it was common for a company to be acquired or have an IPO (or simply die and go away) within 4-6 years of founding. For most companies this time frame is now in excess of 10 years (and depending on the source, more than 12 years). In some cases a shorter vesting schedule makes sense, with additional layering of new grants for those who stick around.  In other cases vesting should be extended to align great talent with truly great achievement.
  • Sharing financial information and educating employees on their awards and the success of the company is perhaps the greatest missed opportunity for most companies. Very early on, you may not have anything useful to share, but as you grow and build a relationship with these individual who will share in your success, you should share your story and financial information.  People will not act like owners if your refuse to treat them like owners.
  • There are strong arguments for options terms far shorter than 10 years and far longer. Shorter terms 3-7 tears may allow you to recycle your equity and relign your strategy as your company grows up and the world changes.  Very long-term grants (terms of 20-25 years) used to be far more common. Given the recent reticence for big companies to have an IPO and given that you may not have a strong IPOP market every year AND given the growing strength of the secondary markets, a longer term may be justified.
  • Grace periods at some companies have recently been extended to the full term of the grant. This sounds super-awesome, but it is really only practical for companies who don;t expect to need a lot of employees before their liquidity event (these reasons for this would be a post on its own).
  • Grant price is generally determined pursuant to IRC 409A through the utilization of a third party valuation firm.
Following common practices very early on can be a quick and easy way to get a program off the ground and active.  But, beware of the traps hidden by “simple” solutions.  Unless your company, the market and your employees will remain simple, the “most common” approach is likely to serve your VCs better over the long-term than it does the founders or the employees of your company.