In last month’s article I discussed the fact that 1 in 7 ventures are run by solo-founders. These entrepreneurs prefer more control and must maintain a deep mental strength to hold themselves accountable for growth. We also discussed that many startups are led by a small group of co-founders. They prefer speed over control and will give up ownership to build a strong team to maximise growth and stay ahead of the competition. We ended the article discussing securities used to issue employee ownership.
Although there are many different types of securities that can be issued to founders and employees, I’ll only mention the two most common:
‘Founder stock’ or ‘restricted stock’ is given to the founder(s) and early team members. It will have vesting provisions typical to options but triggers immediate taxable income to the recipient. It’s therefore only given early in the startup’s life when the stock isn’t worth much or a senior executive is hired that can handle the tax burden. When the employee leaves, the company has the right to repurchase the unvested stock.
The reason for the vesting provision is that the company must have control of how founders and staff sell their vested stock. It must be done in an orderly and structured manner. The key is that the company doesn’t want the sale of shares to conflict with any capital raising/share issuance efforts. If they happen simultaneously, the capital raise will be undermined. These special vesting provisions for founder stock can also be applied to early stage investors, such as angel investors.
‘Stock options’ are the most common type of securities issued to staff. This option gives an employee the right to purchase common stock at a time in the future at a set price. Options are issued at “fair market value” and therefore are not taxed. They are a great way to compensate employees. However, beware that when you do exercise your options, you will get taxed. It’s wise to seek professional advice as to the size of your potential tax bill prior to exercising.
A friend of mine who left a medical device startup after 3 years has decided to return his stock options to the company. He has the usual 90 days in which to exercise his options into shares after his final day at the company (this is a typical timeframe that companies mandate for exercising stock options). Even if he exercises the options, he will own shares in a private company he can’t monetise until there’s an exit event such as an IPO. The tax bill he would receive would require him to take out a loan to pay for it. To solve this problem, Pinterest recently decided to allow people to exercise their options for up to 7 years after leaving the company.
Here is the difference between founder stock and stock options: when you’re issued founder stock, you own the entire amount immediately, but are restricted to a repurchase right the company has on the unvested amount. When you’re issued stock options you don’t own any of them initially but earn them according to a preset schedule over a period of time.
Founder stock has many other rights that are written into the founding documents, in addition to vesting. One of these is having the ability to accelerate the vesting schedule upon a sale of the company. This right should be avoided. Another is having ‘dual class voting’ founder stock, which allows for class A shares to have 10 votes versus only 1 vote for class B shares. Facebook is known for having this as it allows Zuckerberg to fend off activist investor attacks and make decisions with a long-term view. The other rights are beyond the scope of this article.
What is vesting?
Vesting means that an employee earns her stock options over a set period of time. Companies grant options either when an employee is hired and/or after they’ve been employed for a few years, which are called retention grants. In both instances vesting is used. Vesting is also commonly used for private pension plan matching in the UK or 401K matching in the US. I’ll have a future in depth article on HR benefits and how they play into the financial statements and cash flow.
A vesting schedule will show you the timing of when you receive ownership of your shares. If you leave the company prior to full vesting, then the company gets all or some of your options back and it goes into the ‘option pool’. The ‘option pool’ is beyond the scope of this article and will be revisited when we discuss company valuation.
A typical vesting period in Silicon Valley is 4 years with a 1-year cliff as shown in the 4th column of the table above. After 1 year the founder fully owns 25% of its shares and then earns the rest in monthly or quarterly increments over the next 3 years. A 1-year cliff means that the founder must be at the company for at least 1 year to receive the first tranche. The reason for the 1-year cliff is to protect the company from bad hires. For example, if someone will receive €10,000 after 4 years and leaves the company after 6 months, they’ll receive €0. If they leave after 1-½ years, they’ll receive 37.5% or €3,750. The amount of the options that are vested each year equals the employee’s equity compensation.
Investors prefer both teams of co-founders and solo founders to have vesting schedules. It’s akin to having skin in the game and sets a good example for the employees.
When you’re issued stock options you don’t own any of them initially
Co-founder vesting should be set up to resolve the problem when one of them decides to leave the company after only 1-2 years. When the founder leaves, the company can repurchase his unvested shares by simply writing a check. The departing founder will receive the same price per share as originally valued at inception thereby giving him his money back. Investors don’t want to invest in a company where the founder is able to leave after, for example, 1 year with a 40% equity ownership. The remaining team will be left with only a 60% equity stake as a reward for actually building the business to a point where it can be sold.
When co-founders move apart, it’s important to show that the separation was amicable and there remains a good partnership among the separating founders and the remaining cofounders. One company I’ve done work for had one of its co-founders leave the day-to-day operations to pursue research and a PhD. The Board suggested publishing an article or press release to be transparent about the change in role to investors, customers, and the media at large.
Vesting becomes more complicated upon the sale of a company and we’ll leave a discussion of that to a future topic on mergers and acquisitions.
Employee equity is a complex topic and it’s important to hire an experienced startup lawyer to help you navigate the intricacies. It’s highly likely you’ll make some very expensive mistakes otherwise.
In last month’s article I introduced the capitalisation table. The ‘cap table’ provides a snapshot at any moment in time of who owns the company and how you have raised money (securities issued).
Once you’ve decided to move forward as a team, how do you formalise the partnership with your co-founders? Have these conversations early on while everyone is still on good terms. 73% of startups split equity within a month of founding and make a final decision as to who has the role of CEO. If at any point in the future another co-founder thinks they can do the CEO role better, it’ll pull the company and relationship apart.
Don’t be afraid to use an attorney to create a detailed legal document and a buy/sell agreement. You want any co-founder’s shares absorbed back into the business in an orderly way, whether he leaves or something unexpected happens to him.
Let’s say you’re scaling your company and all equity ownership issuances ended a few years ago. Should you now offer one of your key employees the opportunity to own part of your company? This equity buy-in by the employee should be viewed as a massive promotion and investment to allow entry into the executive circle of the company as a “partner”.
Many times, a buy-in could require the individual to take out a bank loan or at least use a significant amount of personal savings.
Be careful to vet the employee and her appetite for risk when making such an offer. The employee might feel in a bind, because accepting will immediately propel her into a prime seat at the table but rejecting the offer risks upsetting the partners at the company. A rejection can infer: “I’m not willing to take the risk you’re taking to invest into the company.”
It’s not for everyone, as ownership equals risk. But not giving equity ownership can mean your best people leave to seek career and financial opportunities elsewhere.