Posted on Dec 4, 2015 by in Compensation Programs, Compensation Solutions

Stock options have often been the carrot on the stick for cash-strapped private venture-backed companies (i.e., start-ups).  But like the San Francisco skyline, times are changing.  Are stock options still the golden ticket to employee attraction, motivation and retention – or are we in need of an equity plan tune-up?

Stock Options at the Early Stage Start-up Company: “That New Car Smell”

Enter Jane:
A recent graduate with a masters in Software Engineering and currently employed by a large Bay Area tech company (“BigTech”), Jane is considering a job change.  She’s been offered a position as a database engineer at a small private venture-backed company in San Francisco generating a lot of buzz (“StartUpCo”).  The offer includes base salary of $100,000 — less than what she is making at BigTech — along with 20,000 stock options in StartUpCo.

While Jane isn’t excited about the pay cut, she is attracted to the offer because of what could be.  The stock options give Jane “skin in the game”, allowing her to become an owner in a growing company.  StartUpCo looks like it could be the next hot IPO. She would share the potential upside growth potential with the founders and other shareholders.  There could be a big check in Jane’s future, upon acquisition of the company or transition to a publicly-traded company. This could be Jane’s big chance.

But stock options are not perfect. The absence of an exchange upon which to trade the shares makes it difficult for Jane to evaluate the potential dollar value of those 20,000 shares, nor does she know when she would ever be able to realize the value of (i.e., sell) her stock options.  Additionally, Jane knows that as more capital is raised, her ownership percentage will decrease, potentially reducing future upside potential of the stock.  And, if she ever is able to sell her stock options, Jane will have to pay income tax on the “spread” (the difference between grant and strike price) and may not be able to afford the tax bill due to rising valuations.

Enter StartUpCo:
Recently having completed its second round of funding, StartUpCo is an early stage company needing to invest in product development, marketing and sales, and growing a staff of talented employees to drive revenue growth.  StartUpCo recently extended an offer of employment to Jane.  Market rate salaries for talented resources such as Jane are expensive and a drain on cash resources. As a trade-off for paying somewhat below-market salaries, stock options are commonly provided to employees of young companies as a primary method of compensation in order to minimize cash costs.  Additionally, StartUpCo likes that stock options align their employees’ interests with those of their shareholders’: take on some of the risk and reap in the reward.

StartUpCo hopes Jane will be attracted by the potential upside they can offer her, but also realizes it may be difficult to pitch the value of their stock options.  The slowest IPO market in two decades[1] coupled with extended periods of private funding[2] mean that employees may have to wait a lot longer to cash out stock options.  People are impatient: the longer the time between grant date and equity liquidity, the more difficult it is to continue to generate excitement and anticipation about the potential future value of the stock options.    Additionally, StartUpCo may not have the reserves to grant Jane more stock down the road and her initial option may no longer hold retention value once it is vested.  Lastly, StartUpCo will need several more rounds of capital funding to sustain its growth, and while intended to enhance the value of the company and its share price, some employees see funding events as limiting the potential future cash in their pocket.

Stock Options at the Later Stage Company: “Not Running Like It Used To”

Enter Jane (+ five years):
Against the advice of her parents to stay with the stability offered at BigTech, Jane accepted the job at StartUpCo!  She determined that a reduction in cash compensation was worth the potential upside opportunity.  However, much has changed for Jane in five years.  In addition to being promoted to Director as recognition for her outstanding contributions to the company, Jane also has had a child.  She now needs cash to purchase a larger home.  After several rounds of funding at StartUpCo, Jane no longer feels the same sense of ownership and is frustrated that her stock options still have no actual value. She begins to wonder if she should look for a new job at a publicly traded company, one that could offer either higher salary or stock with existing value.

Enter StartUpCo (+ five years):
Raising $100 million in capital, StartUpCo has grown from 50 employees to 500 but has done little to change its employee value proposition.  StartUpCo still provides its employees with stock options upon hire, but has been forced to reduce grant levels due to a shrinking share pool.  StartUpCo is struggling with its growing pains: increased turnover, changing culture, and general unhappiness as stock options vest but there is no way to sell them.  Now at a critical juncture in its growth cycle, it needs to address issues with its equity plan to keep compensation packages attractive and motivational. StartUpCo cannot afford to lose talented and experienced employees like Jane.

With limited cash, what could StartUpCo do to at this stage to improve employee retention?

Our Perspective – “Time for a Tune Up”

Despite longer time horizons to capital events, stock options remain a good value proposition, regardless of a company’s future.  Like any car, its effectiveness is a product of how effectively it’s used and how well it’s maintained.  The key is to develop, and communicate to your employees, a thoughtful plan.

Suggestion 1: Focus on communicating the value to the participant

We believe regular communication paired with stock valuations and a few key messages can assist in emphasizing the importance and effectiveness of stock options:

  • It is an incentive and an investment, not an entitlement. The stock option holder is motivated to see the company turn a profit.  Success generates potential dividends and stock value gains but is balanced with the risks associated with any investment.
  • We are all in this together. A typical start-up grants stock options to all employees, not just the top executives.  Share the risk, share the upside.
  • Granting stock options is in line with prevailing market pay practices. Stock options are competitive practice for start-up companies because they align employees, management and shareholders alike with the goal of creating value.
  • Potential for growth and value realization. There is potential for tremendous upside for all levels of employees upon a liquidity event.  Nothing is guaranteed, but keeping “eyes on the prize” orients everyone toward the same goal.

Suggestion 2: Consider liquidity alternatives

Creating recurring liquidity opportunities for employees dramatically increases the perceived effectiveness of a company’s equity program but may not be appropriate until later stages of business.  Depending on a company’s cash situation there are several alternatives:

  • Consider a private tender offer. As companies stay private longer and valuations increase, the demand to provide partial liquidity to employees has grown[3].  Broad-based private tender offers have grown in popularity, allowing eligible employees to “relieve liquidity pressure” through partial sale of shares to a third party.
  • Consider stock repurchases.  As a private company matures and transitions away from granting broad-based stock options, share ownership tends to transition from exit-focused value creation to “retirement plan.”  One alternative for private companies is to provide opportunities for employees to “cash-out” their shares upon termination through company repurchase.  These repurchases typically are limited to owners (i.e., employees with exercised options or owned shares) and may be purchased at a fraction of current valuation price.

Suggestion 3: Consider other forms of equity depending on stage of business

While a minority practice at start-up companies, other forms of long-term incentives could be considered depending on the stage of business:

  • High-valuation late stage start-ups have less emphasis on growth. Consider including Restricted Stock Units (“RSUs”) as part of the new hire and promotional grant practices. RSUs provide immediate equity (as opposed to an option to purchase equity) and are particularly effective at late state pre-IPO companies with valuations not likely to increase dramatically.  RSUs emphasize retention by preserving the value of equity (i.e., by definition cannot go “underwater”), allowing employees to become owners without having to “buy-in,” and reducing stock dilution.  However, RSUs do not have the same emphasis on stock price growth and have an immediate tax implication to employees upon vesting.
  • Mature private companies with no exit strategy have no liquidity options. Long-term incentive cash plans are the most prevalent[4] form of long-term incentive for mature private companies, used exclusively for executives. Freed from the direct tie to company valuation, these incentives are paid in cash based on the achievement of multi-year operating performance measures such as profitability and revenues.  Long-term incentive cash plans allow for immediate cash flow to the participant and flexibility to focus on near-to-long term (often 1-3 years) operating objectives.  However, many companies find it difficult to set multi-year performance goals and to distribute the amount of cash needed for market-competitive payouts.
  • Frequent regular grants of long-term incentives to executives emphasize retention. While it is common for start-up companies to provide a one-time grant upon hire, many mature private companies provide regular cyclical long-term incentive grants to executives[5] in order to retain high value employees.  It is not common to provide recurring long-term incentive grants to employees below the executive level.[6]
  • Creation of a private exchange. Private exchanges allow owners to have a liquidity event by selling their shares to other owners.

Stock Options At Any Stage: “The Family Wagon”

It’s taking longer to get rich quick.  Once thought as the key to success for attracting talent to start-up companies, stock options are taking longer to see value and are worth less.  But the potential upside of stock options is still tremendous.  If a start-up company makes it to an IPO or acquisition event, employees can be richly rewarded based on the growth in value of the shares they are entitled to purchase.

Stock options are still a great device for any start-up.  Here is our summary for how to retain star-performers like Jane, as the start-up company grows up:

  1. Emphasize value to employees. Jane needs to clearly understand the vision for the future and emphasize how stock options are a component of a market competitive pay package.
  2. Create liquidity. Create recurring opportunities to create cash flow for employees like Jane and other shareholders.
  3. Don’t be afraid to use different tools. As business objectives change over time, review your equity program to gradually include a portfolio of long-term incentive vehicles.

Careful planning and implementation of the right plan will keep highly valued employees like Jane motivated. The right plan will keep Jane engaged in working hard while she waits for that hoped-for big check – the share of company value Jane helped create.

 

[1] “Tech Startups Feel an IPO Chill.” The Wall Street Journal. October 19, 2015.

[2] “Is The IPO Outmoded? Why Venture Backed Companies Are Waiting Longer To Go Public.” Forbes. December 24, 2014.

[3] “Private Tender Offer Best Practices. How to Deliver Controlled Liquidity as a Private Company.” 2015 SecondMarket Holdings, Inc.

[4] WorldatWork and Vivient Consulting. Incentive Pay Practices Survey: Privately Held Companies.” February 2014.

[5] WorldatWork and Vivient Consulting. Incentive Pay Practices Survey: Privately Held Companies.” February 2014.

[6] WorldatWork and Vivient Consulting. Incentive Pay Practices Survey: Privately Held Companies.” February 2014.