Tuesday, March 4, 2008

Do 4 Year Vesting Schedules Still Make Sense?

Four year vesting is one of the sacred cows of Silicon Valley. It is a birth right. A practice that can not be questioned. The persistence of this labor friendly term in start up comp plans would make the Teamsters Union proud. When it comes to pay packages in Silicon Valley, everything is negotiable EXCEPT the length of stock option vesting. That has to be 4 years. But does this make any sense? On balance, I don't think so. At least not any more.

During the dot com glory days, it was possible for a venture backed company to be formed and go public in 4 years or even less. Of course, many of these businesses were woefully unprepared for public market scrutiny and subsequently failed. But the idea of a 4 year vesting schedule was palatable when a start up could reasonably expect to be pubic in that period of time. Those days are long gone. It takes closer to 7 or even 8 years for a successful company today to go from launch to IPO. So what happens to all of those employees who are fully vested at the 4 year mark? That is an issue many VCs and boards, Clearstone Venture Partners included, are wrestling with.

If an employee's stock is fully vested, what is her motivation to remain in the company from a financial perspective? The answer is not much. She would quite likely be better off going to a new company and receiving a fresh grant of stock options. In another 4 years, she will have twice as many options as she would have had if she had stayed at the first company for the entire 8 years. She will also enjoy some portfolio diversification by having a financial interest in two different start ups. So the value of 4 year vesting makes a lot of sense for the employees. But what about for the company?

Most venture backed companies create option pools of 20% to 25% of the total shares outstanding. The hope is that these pools will be sufficient - plus or minus 5% - for all of the employee stock option grants from inception to IPO. But imagine a scenario where most of the early employees leave after 4 years. Those people will need to be replaced. And those replacements will need new option grants. So essentially the company is paying twice for the same position. And the situation can get quite odd. I have seen companies in which the collective stock holdings of FORMER employees exceeds the amount of stock held by current employees. Hard to see how a situation like that can be good for the current employees (who are creating value for those that have left) and the non employee shareholders. Eventually, if enough employees leave at the 4 year mark, a company has no choice but to augment the option pool in order to back fill the vacated positions. These new stock grants dilute the ownership percentage of every other stockholder - from VC to founder to employee. In summary, 4 year vesting is not a very attractve compensation structure for start ups given the current IPO time line.

What to do about this conumdrum is far from obvious. Ideally, from a company's perspective, stock options would only vest when a liquidity event occurs (wheher IPO or acquisition). If that takes 10 years, so be it. There are a number of drawbacks to this approach from the employees perspective so such a solution is not practical. However, I do believe that 5 or even 6 year vesting should become the vesting standard. As the holding period for venture backed companies elongates, I believe there will be more and more board room dicsussions about what is fair and reasonable with regard to stock option vesting. It was not that long ago when 5 year vesting was the norm, and getting back to that would be a good first step.

2 comments:

Will said...

Hey William -
I am enjoying your blog, though I am not sure I agree with your assessment here (which should not be a surprise since I am usually on the management side of things). As most exits these days are not IPO's, wouldn't your analysis be a little off since the company could very likely be acquired within a 4 year window (especially consumer internet plays). Also, I believe there is still significant motivation for employees, in the absence of an acquisition or IPO to stick around. You want to drive value to the highest levels to ensure your vested options generate the most upside. Finally, I am curious as to your pov around another sacred cow - one year cliffs. Why should senior employees have to wait a year to vest any shares, when in fact the company has been using them to generate value during the course of that year. I understand employees can leave, etc. Yet, if they provide tremendous value for 6 month, why shouldn't they receive equity value for that (to offset what is usually below market cash comp)?

http://www.willanjohnson.com

Big Billy said...

I focused on the IPO as an exit because that is what most VCs are shooting for when they fund a company. Companies going public today have been around for at least 7 years, which leads to the problem of options being fully vested long before that outcome. The M&A route is generally a far less attractive option.

Cliff vesting and regular stock vesting have one thing in common: The desire on the part of the company for the person to remain with the company for some period of time before getting equity ownership Its a judgement call on the time frame needed to earn the stock option but I think 1 year is reasonable. Few employees can join a company, make a meaningful contribution and be gone in less than one year. The 1 year cliff is a way of communicating to potential employees that short timers are not desired. I think that is ok