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Is there a different alternative to 4 yr vesting for stocks?

I am writing because I see several significant drawbacks to the 4 year with 1 year cliff model for equity compensation (though it's clearly much better than no vesting):
  1. Once employees leave the company they can hold on to the stock they have vested. This makes little sense as they continue to benefit from growth without being involved.
  2. Once employees reach the end of four years, they will experience a sharp drop in income from equity (e.g. four years down the line there is no way a CEO would be allowed to accrue a further 10% per year). This greatly reduces the incentive to stay. Furthermore, individuals don't value money in a linear fashion, e.g. the marginal utility of equity that vests in the first year is much greater than in the fourth. This also makes it increasingly hard to incentivise employees to stay as time goes on (setting aside the fact that job satisfaction is probably the dominant consideration).
  3. There are many unfair scenarios (either for the employee or the company) if employees leave:
    1. Directors may feel it is unfair that employees can leave after 2 years with significant stock.
    2. Founders may feel it is unfair that they are asked to vest their stock (something they may originally have viewed as being theirs).
    3. Directors may find it hard to keep employees once their stock has fully vested.
Here's a very different alternative to vesting - Include a buy-out clause for all equity if an employee leaves. The buyout price would be set dynamically in the following way:
  • Every three months, the company's directors will agree on a projected valuation for the company in six months time. The projected value in the intervening period will be defined by a path of constant growth rate from the present time to that six month milestone.
  • The buyback price at any moment in time will be the projected value at that moment divided by the total issued shares. Once an employee leaves, the buyback price would freeze and the company would retain the option to execute the buyback until a time at which it pleases.
Example:
On January 1st Company X is valued at $3m by a seed round of investment. The board meets immediately. The board expects to take in a $3m investment in one year's time - at a valuation of $10m. Based on this, and assuming a constant growth rate, the board projects the value of the company to grow at roughly V=$3m X exp(1.2 X time) over the next three months. This formula (in conjunction with the number of issued shares) is used to calculate the buyback price if an employee leaves. The formula is adjusted by directors every three months.

Here, in my opinion, are some benefits:
  • Employees will be appropriately rewarded for growth in the company's value while they made an active contribution.
  • Company directors are forced to constantly value the business. This in itself is beneficial in my opinion. Furthermore, there is a beneficial tension between giving a high valuation to make the company look good and giving it a low valuation to make sure that the buyback price isn't too high.
  • Overall, I think this could lead to more fair scenarios for employees and for the company if employees leave.
    • If employees leave after 2 years they get a return and directors get their stock back.
    • Founders keep their stocks until they leave (no forced vesting).
    • Employees no longer leave because they have finished vesting.
What are the major risks with this approach? How could it be improved?

11 Replies

Michael Brill
5
0
Michael Brill Entrepreneur
Technology startup exec focused on AI-driven products
1.I don't understand the logic. Byextension, any early stage investor should not be entitled to capital appreciation if they do not participate in future financing rounds. If someone puts in a couple of years to set the stage for future growth, why shouldn't they benefit from that?

2. Fully vested, with a large equity stake, your individual efforts have a huge impact on your personal wealth... that's enough motivation. You don't need more equity. If you don't have a meaningful impact on business and you are fully vested, then by all means move on. I don't think I agree that the marginal "utility" of equity vesting is greater in year one than four. 25% equity in year one of a completely unproven entity is worth much less than the same 25% equity in year four of a successful entity.

3. None of this seems "unfair"

There are all sorts of problems with the proposal (e.g., conflict of interest for board setting value), but fundamentally I think you might be trying to solve a problem that doesn't really exist... and I certainly don't agree with the bias that the value of a person's contribution ends the moment they leave the company.

Johnson Ma
1
0
Johnson Ma Entrepreneur
Business Development & Strategy
Completely agreed with Michael.

There are quite a few flawed assumptions in the proposal that make it a mess, in my opinion -- the idea that a person's value just abruptly stops when they leave (what if it's a person who proposed a feature or new product line that forms the basis of millions in future revenue?), the idea that "forecasting future value" of a company (six months in advance even!) is a "fair" process, that most employees can even navigate this process so that you can hire properly...and so on.


Karl Schulmeisters
0
0
Karl Schulmeisters Entrepreneur
CTO ClearRoadmap
If you are worried about a hired CEO acquiring more than 10% of the stock some time in future, for a company that hasn't even launched yet.... you probably ought not be in that line of business, and I'd question if you have the mindset for a groundfloor entrepreneur.

The reality is that the long odds are that your equity as a founder/co-founder is going to be worth nothing. And you need to go into it with that recognition. this whole notion that there is utility of stock that is vested that has no market value is just silly. There may be theoretical value in those shares but until there is an opportunity to sell them they have no value

Founders typically don't vest their stock BTW. The reason being that when an investor wants to invest, they want to know what percentage of the company they are buying and how the shares are allocated. And founders typically want to have more than 50% vested control, as do early stage investors (hence a conflict).

Typically Founders come up with an allocation agreement amongst themselves setting aside a pool for early stage staff and advisors and another pool for investment. At subsequent investment stages the foundersand investors typically dilute their ownership.Using your example

the $3m coming in to value the company at $10m means your investor(s) got 30% of the company.
now lets assume there is Founder A and Founder B each with 26% of the company. that's 82% gone.

Another 5% goes to various early stage advisors in lieu of cash compensation leaving 13% for employees.

CEO gets 10% over 5 years
leaves 3% to be distributed to say 2 employees.

3 years down the line the company meets a 5x growth rate and the VC A round gets a $40 mill purchase proposal. But they want 40% of the company. for that.

This means the original $3 million investor sells out 30% for $30 million (the 10x growth his investment contract called for) and the Founders each toss in 5% of their 26% leaving them with 21% each and a cash injection of $10 million.

Alternatively you could say that each of the remaining 70% share holders have to give up 1/7th of their holdings to the new investor, but of course the employees will be unhappy.

but the bottom line is that you are getting diluted unless after 3 years you are selling for $100million (the only way that a 30% investment can be cashed out for $30 million) .
Karl Schulmeisters
0
0
Karl Schulmeisters Entrepreneur
CTO ClearRoadmap
Basically if you go in with the attitude you seem to have about ownership and contributions by employees, your likelihood of attracting top talent and your ability to focus on the actual startup issues is not likely to gain success

Kate Hiscox
0
0
Kate Hiscox Entrepreneur • Advisor
Boss at Venzee
This is an interesting discussion and I agree with some of the points above. I really only have two words to contribute, "investor friendly". There are varying degrees of friendly of course! But whenever dealing with this stuff, always try to avoid creating hurdles for yourself down the road.
Roger Wu
1
0
Roger Wu Entrepreneur
co-founder at cooperatize, native advertising platform
Why spend money on stock buybacks? In theory there should be a greater return by reinvesting in the company as opposed to buying back shares.
Karl Schulmeisters
0
0
Karl Schulmeisters Entrepreneur
CTO ClearRoadmap
Roger you made a great point that I was thinking about as well. If I were the investor who put $1mil into the company, I would hate ... absolutely hate... to have the money I invested in the company on the assumption that it would be spent to build the product... instead see the money get spent to preventa developer who leaves early from getting the benefit of the equity appreciation that may never happen???!!!???

That's just mismanagement of resources
Rob Gropper
0
0
Rob Gropper Entrepreneur
Director at PetHero, SPC - Member at Eastside Incubator - Principal at Tuxedo Technologies Group
@Ronan, your plan is detailed and i'm sure a lot of thought went into it - i've not spent much time to consider its merits, but i don't thing it's necessary to reinvent the wheel here. Right of first refusal for the company to buy back options is not uncommon in stock option plans. Also, maybe i'm missing something here, but it is also a common practice (perhaps not as common as i might think, but it is our policy) to keep replenishing the carrot with new options each year ("evergreen option grants"). No one wants key employees leaving once their options vest so a simple method is to continue to award more options each year with, of course, a vesting period for these new options. You want 1) to avoid creating an artificial 'cliff' where an employee has a reason to start looking for greener pastures just because his/her 4th year rolls around and s/he is fully vested and 2) you want fresh incentives out in front of them at all times to keep them motivated and swinging for the fence. Here's a good explanation of how and why that works: http://firstround.com/review/The-Right-Way-to-Grant-Equity-to-Your-Employees/
and here's a SlideShare with some details:http://www.slideshare.net/wealthfront/wealthfront-equity-plan

David Schreiber
0
0
David Schreiber Entrepreneur
Founder
  1. Once employees leave the company they can hold on to the stock they have vested. This makes little sense as they continue to benefit from growth without being involved.

I've worked in a technical role in several startups. Were I looking for a job, the above sentences would immediately disqualify you and your company as a potential employer for me.

Current startup stock option plans rarely pay out to startup employees. And even when the startup is successful, sometimes executives and investors will find out ways to ensure ordinary employees don't get their payout (e.g. Zynga, Skype).

So trying to figure out how to tilt option plans even more in favor of investors and employers is only going to sabotage your chance to hire the talent you need. Not just because of the details of the plan, but because potential hires are going to assume that an employer who's passionate about employees not getting "too much" is likely to find ways to claw back employee equity in the unlikely case that the company is successful.

I'd suggest instead taking a page from Pinterest, and look for ways to make your stock option plan more appealing to potential hires, not less:

http://fortune.com/2015/03/23/pinterest-employee-taxes/


Sridhar Rajagopal
0
0
Sridhar Rajagopal Entrepreneur
Software Engineer, Maker, Tinkerer
Lots of excellent points above! Here are my own 2 cents!

1) You have two options - pay the employees for the work they do. Period. Or, give them equity to partake in the success of the company (or a combination of pay+equity)

If you choose the equity (or pay + equity) option, it is understood that the employees are taking a big risk with no or low pay, with every possibility they may not see much more out of it.

The vesting term is to encourage them to go on the often bumpy ride together, to invest in the success of the company. The vested equity, on the other hand, represents pay for work already done (which may or may not amount to anything at all, in the end). So yeah, if the company is successful, they partake in the success even after having left after a year - put yourself in the employees shoes - majority of startups do not make it anyway - they may be left with diddly-squat.

If you don't want that, you can always go the pay the employee route - you cannot eat the cake and have it too!

As for equity, it is not a one time thing, so that after 4 years (or however long), the employees are left with no incentives. Based on their performance, and the company's growth (this is what everyone is working towards right?), there will (or should) always be additional carrots in the form of pay/equity/both.

As for your points #2 and #3, you are assuming that the value of the company and the outstanding shares remains stagnant over time. As the company grows and there is more investment, the "significant" shares that an employee leaves with after 2 years will not longer be as dear. It will get diluted.

My own opinion on buyout is mixed at best. If someone has put in the time and has vested the shares (over whatever time period is deemed suitable), then they own it and can (or should) be able to do with it as they please - at that point in time, they also own a piece of the company, however small. Buyout should be an option, but shouldn't be forced down the throat, in my opinion.

-Sridhar
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