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The Compensation Series: All about Equity.

Jul 21 - 2022 | 5 min read
THOMAS MOLENAAR

Many tech companies offer equity in their compensation packages to executives and some even to their more junior employees. However, they rarely do a good job of explaining how it works. Given its complicated nature, employees often lack enough financial knowledge to evaluate and make informed decisions about the equity they are offered, much less about the practicalities of exercising them. To realize the potential value of equity, it needs to be understood first.

What does it mean for the employer?

In essence, a stock option is a right, but not an obligation, to purchase a given quantity of shares at a set price for a fixed period of time. Offering employee stock options enables startups to attract top talent and retain them as they scale, in the face of tremendous competition from establishments with deeper pockets. Employers are able to strengthen their relationship with their employees as their efforts are directed toward the common goal of the company’s growth and long-term success. The fact that stock options vest over several years and appreciate with valuation also disincentives the tendency to leave the company.

What does it mean for the employee?

The most striking opportunity that startups provide employees is the chance to make a visible impact with the work they do. Additionally, when employees are offered a tangible stake in the company’s future growth, they are personally motivated to work harder for the success of the company. Stock options make it possible for them to be rewarded financially for their hard work, in a way that extends beyond their annual pay.

Understanding key terminology.

The vesting period is the length of time the employee must wait before they are able to exercise their ESOs. Typically, no options are vested during the first year called the cliff. A cliff designates a period of time that the person must work before they vest at all. This aims to encourage new hires to stay committed to the company for a significant period of time as well as to allow the company to eliminate any mis-hires without suffering dilution.

The right to exercise stock options traditionally vests over a four-year period, at predetermined dates as subject to a vesting schedule set by the company. This may come with a cliff, usually a one-year cliff from the grant date, but sometimes that can be negotiated away. This allows the holder to buy the first 25% of their shares at the end of year one, after which they vest monthly. To put this in perspective, imagine you leave before completing a year, you get nothing, but if you leave after three years, you get 75% or after four years, you get 100%.

There are two alternatives to the traditional vesting schedule: backloaded vesting and performance-based vesting. Companies that follow back-loaded vesting deviate from giving their employees a quarter of their options every year, to follow schedules that vest 10% after the first year, 20% after the second, 30% after the third, and 40% after completing the fourth year. This approach is adopted as a way to encourage long-term retention, as employees are rewarded for their loyalty with the opportunity to maximize their vesting.

Some companies reward their senior executives with performance-based stock options rather than time-vested ones. This means that employees are given stock options only if they hit targets like revenue growth, which drives long-term value.

Strike price, also referred to as option price or exercise price is the amount an employee should pay to buy each share. It’s a fixed price for the given option grant and is usually the Fair Market Value (FMV) of the company’s stock on the day the option is granted. Only if the current share price of the company exceeds the strike price does it make sense for the holder to exercise options.

For instance, if each share is priced at $1k when the contract is signed, it means you have the right to buy the shares later on at that price, irrespective of what they are worth in the market. In the case of an exit event four years later, if the price has risen to $20k per share, you will receive $19k per share, i.e, the current share price ($20k) minus your strike price ($1k). Essentially, $19k is the value you have co-created.

Strike prices exist to ensure that, for the value they create, an employee who joins a startup in its early days must be rewarded more than someone who joins later on.

What happens when an employee leaves?

If an employee leaves the company before their stock options have fully vested, they will retain rights over the vested portion and the unvested portion gets canceled to be returned to the unallocated ESOP pool. Half of the European startups allow employees to keep their vested options when they leave but do not allow exercise until the event of an exit. Employees who are let go due to instances such as violation of laws or fraud are asked to return all their shares.

What happens to the stock options when a liquidity event takes place?

During an Initial Public Offering (IPO), shares from exercised options become tradable in the listed company, whereas unvested options typically continue to vest following the IPO.

In the case of an acquisition, the acquiring company generally puts a new retention program in place for key employees. Unvested options lapse. Exceptions could be made particularly for individuals like the CEO, CFO, and General Counsel, by providing them with provisions to partially or fully accelerate the vesting terms for their option grants.

Evaluating stock options vs. cash.

The company’s potential for success is one of the most critical factors to be considered while making decisions about the cash-for-equity tradeoff. If you don't have enough information to evaluate the company, the decision could get tricky. The size of the market they operate in, the business model, and profitability are all factors to be taken into account. All things considered, if the mission of the company has the potential to take it to greater heights, stock options could prove valuable.

How long you plan on staying with the company has a bearing on whether or not stock options are potentially beneficial for you. The rationale behind share vesting is that the longer you stay with the company, the more shares you receive. If you see yourself spending only a short amount of time with the company, say less than a year, then it would make more sense to receive your compensation in cash, as options are not property unless they vest.

While evaluating a compensation offer, it is important to know whether the cash-for-equity number the company is offering is a fair tradeoff. To do that, the company should also be willing to share the necessary information you may need to calculate that. An employer’s reluctance to negotiate particularly unfavorable terms could be a red flag for the employee.

What does the fast-paced startup landscape mean for the curation of ESOPs?

Initially, venture capital structures were set up for a reality where successful companies exited in six to eight years and did not raise enormous capital. Cut to the present, startups are receiving from venture capital growth funds, the cash they would have received at an IPO. This has deterred the need for an IPO for another five years, enabling VCs to capture the increase in market cap of the company. Subsequently, their market cap at IPO time will exceed unprecedentedly.

Considering this shift of liquidity goal posts, stock options with four-year vesting periods no longer incentivize employees to prefer working for a startup over a large company, as it may take significantly longer than it used to for a company to go public or be acquired.

Replacing early employee stock options, say for the first key hires, with the same Restricted Stock Agreements (RSAs) as the founders is a possibility.

Companies, especially larger startups could consider offering restricted stock units (RSUs) for other employees. RSU is an option with a $0 purchase price. Whereas stock options give holders the right to buy the company’s shares at a future date, RSUs give holders a commitment to receive the value of a certain number of shares in the future without requiring payment upfront.RSUs vest too, but employees ought to be allowed to buy their vested RSU stock and sell it every time the company raises a new round of funding.

With something as potentially life-changing as equity, it is worthwhile to demystify how it works, to empower employees to rightly interpret its various components and base their decisions on true understanding. Fair, clear, and mutually beneficial contracts contribute to highly productive collaborations with employees, in turn impacting the bottom line positively. Therefore, compiling a talent-friendly ESOP could certainly be rewarding for companies, both in terms of attracting and retaining top talent as well as fostering an environment of trust and encouragement in the long run.

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