On its surface this was a pretty radical idea.
Employee Stock Option (ESO)
The types of options for employees were giving away part of their ownership of the company—not just to the founders, but to all employees. Why would they do that? Startup employees calculated that a their hard work could change the odds and b someday the stock options they were vesting might make them into millionaires. And the bet worked.
While founders had more stock than the other employees, they had the same type of stock options as the rest of the employees, and they only made money when everyone else did though they made a lot more of it. Everyone—investors, founders, and startup employees—was in the same boat. Therefore, the time until a liquidity event was crucial.
Of the four startups I worked at that went public, it took as long as six years and as short as three. How Startup Compensation Changed Much has changed about the economics of startups in the last two decades.
And Mark Suster of Upfront Capital has a great post that summarizes these changes. The first big idea is that unlike in the 20th century when there were two phases of funding startups—Seed capital and Venture capital—today there is a new, third phase.
What is an Employee Share Program?
And currently there is an influx of capital to do that. The emergence of growth capital, and pushing an IPO out a decade or more, has led to a dramatic shift in the balance of power between founders and investors.
For three decades, from the mids to the early s, the rules of the game were that a company must become profitable and hire a professional CEO before an IPO.
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That made sense. Twentieth-century companies, competing in slower-moving markets, could thrive for long periods on a single innovation.
Stock Options \u0026 Restricted Stock
If the VCs threw out the founder, the professional CEO who stepped in could grow a company without creating something new. In that environment, replacing a founder was the rational decision.
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But 21st century companies face compressed technology cycles, which create the need for continuous innovation over a longer period of time. Who leads that process best?
How Do Employee Stock Options Work?
Often it is founders, whose creativity, comfort with disorder, and risk-taking are more valuable at a time when companies need to retain a startup culture even as they grow large. With the observation that founders added value during the long runup in the growth stage, VCs began to cede compensation and board control to founders.
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While founders in the 20th century had more stock than the rest of their employees, they had the same type of stock options. Rather, when a startup first forms, the founders grant themselves Restricted Stock Awards RSAs instead of common stock options. Essentially the company sells them the stock at zero cost.
In the 20th century founders were taking a real risk on salary, betting their mortgage and future. Founders take a lot less risk, raise multimillion-dollar seed rounds, and have the ability to cash out way before a liquidity event. Early employees take an equal risk that the company will crater, and they often work equally as hard.
Consider that the median tenure for an employee in a startup is 2 years. So why should non-founding employees of startups care?
Different types of employee compensation
There are four problems: First, as the company raises more money, the value of your initial stock option grant gets diluted by the new money in. So while the VCs gain the upside from keeping a startup private, employees get the downside.
At the same time, they may have removed one of the key incentives that made startups different from working in a large company. What Should Employees Do?
In the past, founders and employees were aligned with how to trade with the trend same type of common stock grant, and it was the VCs who got preferential stock treatment. The founders and very early employees have preferential stock treatment and the VCs have preferred stock.
Add to that all the other known negatives of a startups: no work-life balance, insane hours, inexperienced management, risk of going out of business, etc. That said, joining a startup still has a lot of benefits for employees who are looking to work with high-performance teams with little structure. Your impact will likely be felt. Constant learning opportunities, responsibility, and advancement are there for those who take it. What Should Investors Do?
For later employees, offer what are called restricted stock units RSUs.
Best Types of Options for a Situation in General
The lower the strike price, the less you have to pay to own a share of company stock. But to keep employees engaged, they ought to be allowed buy their vested RSU stock and sell it every time the company raises a new round of funding. Today, venture capital growth funds are now giving startups the cash they would have received at an IPO. And the market cap at IPO time will exceed anything yet seen for startups.
Investors and founders have changed the model to their advantage, but no one has changed the model for employees. Moving the liquidity goal posts may have removed the incentive for non-founders to want to work in a startup versus a types of options for employees company.
Stock options with four-year vesting period are no longer a good match for employees when it may take 10 to 12 years for the company to go public or be acquired. He has been either a cofounder or an early employee at eight high-tech start-ups, and he helped start the National Science Foundation Innovation Corps and the Hacking for Defense and Hacking for Diplomacy programs.
He blogs at www.