The Tricky Art of Setting Terms in Employee Stock Option Plans
The 14th in a series of blogs on launching, growing and ultimately selling a technology company, with a corporate finance focus. Topics will cap structures, equity plans, financing, corporate partnering, board matters and how to achieve a successful exit.
You have put an option plan in place and determined who and how many options to grant to your team. Now, what about the terms?
Vesting and expiry terms
The first question you should ask yourself is whether the options are being granted in lieu of salary in a material way (i.e., employees are not just being slightly underpaid but materially underpaid), or whether the options are being granted as an incentive or retention mechanism (i.e., employees are being paid market or close to market). These are two very different situations.
If the options are being granted in lieu of compensation in a material way, then the options should:
- vest daily, as the services are being provided (just like being paid for each day worked), and
- remain in effect even after the employee is long gone
After all, if you pay an employee in cash and he or she leaves, they don’t give back their pay. However, you might want to consider adding a clause that allows for termination of options if the employee is fired for cause.
If the options are being granted as a bonus and as a retention mechanism, then they should:
- vest over a longer period of time, typically between two to four years, and
- expire shortly after the employee leaves—usually within 30 to 90 days
Timing issues: Daily, quarterly and cliff vesting
With respect to vesting, I like to keep it simple and vest options daily over the vesting period. The issue with quarterly vesting is that it drives quarterly behaviour rather than daily behaviour. The exception to this is for public companies which have to report quarterly. Vesting quarterly makes for less work for the auditors in booking the option expense.
Make sure that new employees start vesting on day one, but also make sure that if they do not survive their probation period all of their options terminate and none vest.
Cliff vesting refers to setting an extended date before any options vest—often six months to one year out. I am not a fan of cliff vesting as we don’t want to encourage people who want to leave the company to stick around a day longer than they actually want to, simply to earn some options. It’s better for the company if they leave earlier and still retain whatever options vested for the period they were there.
Having vesting accelerate on a liquidity event helps get everyone driving hard to achieve an exit. Not including accelerated vesting on a liquidity event can actually be counter-productive, resulting in behaviours which may frustrate a sale. However, when granting large option positions to senior people joining the team, you might want to limit the amount that would accelerate on a liquidity event in their first year of employment in order to avoid unearned windfalls which are dilutive to the rest of the shareholders.
In this instance, I usually suggest that if the liquidity event happens in the first year of their employment, they don’t receive any acceleration but simply have the options they vested over that period. Or, at most, 50% acceleration to prevent windfalls.
Setting an exercise price
Options should be granted at an exercise price equal to the fair market value of the company’s shares at the time of grant. There are both tax and governance reasons for doing this. The value realized from the options should be commensurate with the company’s equity value growth from the time they are granted. Your team should be incented to benefit from the “lift” in value they contribute to.
If you don’t have an independent valuation on the company or an obvious valuation metric to use, the rule of thumb is to price them according to the most recent financing price and adjust for any obvious increase (or decrease) in value since that event.
A useful feature to include in your option plan is a “cashless exercise” feature, allowing the company to pay out the difference between the exercise price and the then current share value to a holder without the holder having to come up with the money to exercise the option. In most M&A deals, this is how the options are paid out. Having this term in the plan can save a ton of work and documentation.
Next up: The do’s and don’ts of raising venture capital and some tips on how to get the financing you are looking for.
David practiced corporate finance law for 20 years representing numerous technology companies before retiring to co-found a venture capital fund where he was a partner and portfolio manager for ten years. He now provides corporate finance/M&A advice to a portfolio of tech companies with a view to growing them to the point they are ready to exit and then leading that process.
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