The Evolution of Stock Options and Why Equity Refreshes are a No Brainer
Long before catered lunches, embroidered Patagonias, and 99% covered healthcare premiums, stock options entered the scene.
In fact, stock options for employees can be traced all the way back to the mid -1970s. Though you would never know it with how misunderstood they are.
So why did companies start offering stock options to employees?
- Salaries were lower than big corporations: stock options provided a way to [sort-of] level the playing field and give employees a shot at that big exit
- Ownership aligns incentives: giving employees a stake in the success of the company would motivate them to work harder and see to its success
But how long would you have to burn the midnight oil before you might have a shot at that big pay-out?
Before the Dot-Com Boom, most startups would IPO in 6-8 years. A few names you may know were even quicker.
Amazon: Raised an $8M total Series A in 1996
Founded: 1994, IPO: 1997
Google: Raised $36.1M over 4 funding rounds
Founded: 1998, IPO: 2004
Salesforce: Raised $65.4M over 6 funding rounds
Founded 1999, IPO: 2004
You may also notice that the total amount of funding raised by these companies is nothing compared to today’s standards. Pave, for one, has already raised more venture money than Google did.
Accordingly, the 4-year vest, 1-year cliff was birthed.
Translated: you must stay at least 1 year to play the game at all, and in order to have all your chips, you must stick it out for 4.
With some of the IPOs we looked at above, this made quite a bit of sense. Stick around long enough to play the game, and you might be on the heels of the next IPO.
Still today - by a long shot - this is usually what the fine print of your lotto ticket reads. And so, an employee signs on the dotted line for a chance at the next big startup.
But does this still make sense?
In a look at the 16 SaaS IPOs of 2020, the median time from founding to IPO was 13 years. Yes, 13.
Next Translation: The 4 year vest will not incentivize your employees to stick around for 13 years - or anywhere close.
So how are companies keeping people around given the new circumstances?
Enter: Equity refresh grants.
So assuming you want to keep your people around for more than 4 years, you may want to [heavily] consider additional equity grants.
A few common strategies:
- The boxcar grant: A new equity grant usually offered in year 2 or 3 of employment that won’t begin vesting until after the 4 year grant concludes. So, the vesting schedules look like boxcars - clever.
- Traditional grant: New grants (usually starting in years 2 or 3) are issued on a 4-year vesting schedule without the cliff and usually begin vesting immediately. In this case, the vesting schedules overlap.
- Performance grant: Grant high-performing employees an additional grant (usually any time after the cliff). Vesting schedules can vary, but typically they start vesting immediately.
- Promotion-commensurate grant: Just as salary changes with a promotion, so the equity grant value should also be commensurate.
- Annual grants: A one-year vesting model granted annually.
There is no perfect approach, only considerations to make:
- Annualized total comp: Consider the annualized value of an employee’s salary + stock option value. A decrease in total compensation in coming years does not optimize for retention.
- Compensation philosophy: Do you have a pay-for-performance model? Do you only adjust compensation for role/level changes? Be thoughtful. More importantly - be consistent.
- Company stage & employee tenure: Equity refresh grants are fairly uncommon when a majority of employees haven’t even hit their cliff yet, but if you’re waiting until you’ve had employees for 3-5 years before rolling out an equity refresh program, you’ll be behind the curve.
- Valuation: Is your valuation increasing rapidly? Remember, 409a valuations are refreshed once a year at a minimum (this means the strike price employees will pay increases each year that you wait to grant them more equity).
- Total rewards: Clearly, there is more to the equation than just salary and equity alone. Consider the weight of other forms of compensation and how you want to reward employees (e.g. cash incentives like bonus and commissions).
As we’ve all begun to observe The Great Resignation of 2021, savvy teams have given retention strategies a fresh look. Very often, equity refreshes are part of that equation.
But the impact of equity refresh grants doesn’t stop there.
Candidates are starting to ask about equity refreshes. They’re seen as an additional benefit and a longer term incentive. So they can also serve as a helpful recruiting tool.
Again - be thoughtful. And be consistent. Don’t wait to establish a strategy until you’ve felt the effects of not having one.
Oh, and if you’re struggling to figure out how to roll this sort of thing out in spreadsheets, you may want to check out Pave.
- Harvard Business Review: How to Make Startup Stock Options a Better Deal for Employees
- Crunchbase.com for funding activity
- Meritech Capital: 2020 Review: SaaS IPOs