Fair Practices Build Culture, Loyalty That Can Withstand Crises
Extend runway. Focus on capital efficiency. This has been common advice over the past few months from VCs to their portfolio companies and Initialized has been no different. Sadly, this meant some companies have had to do reductions in workforce.
In advising our companies through these tough times, it’s become apparent to me that there is a huge divide between investors and founders who believe in treating their employees generously with respect to equity compensation (even when employees are on the way out), and those who do not.
I will start this post with a novel assertion: Employee equity is compensation.
It seems obvious, but attracting and keeping great talent is the lifeblood of any company. Showing employees that they are valued by creating compensation structures in their favor benefits companies in the long run.
Despite this, venture investors and founders have a tendency to want to hoard and restrict equity. In almost 15 years of working in venture capital, I’ve seen less and less favorable terms for employees crop up, even as the industry became more founder-friendly.
Transfer restrictions and rights of first refusal
When Facebook was founded in 2004, founders didn’t think that going public was something to be avoided like the plague. It wasn’t until the company had raised several hundreds of millions that Facebook realized it should implement transfer restrictions on its shares, almost four years after its formation. Consequently, Facebook was fairly permissive on secondary transfers of its shares (subject to securities regulations and rights-of-first-refusal). After the secondary frenzy piqued for pre-IPO Facebook shares, other private companies began to realize that allowing the relatively free transferability of its shares was not a good idea. Now, transfer restrictions and rights of first refusal are now standard conditions of private equity ownership. I’ve seen extreme examples where ex-employees are required to allow the company to buy back their stock. At COST!
I’m starting to see more back-loaded vesting schedules. Last year, one of our portfolio companies renegotiated several senior executives’ vesting schedules to be back-loaded, and then promptly transitioned those execs out. Great for shareholders. Bad for those execs.
Option exercise period
The industry standard option exercise period is 90 days after the employee leaves the company. This means that unless the employee writes a check out of his or her own pocket for the shares, those shares are forfeited to the company. After 90 days, Incentive Stock Options (ISOs) turn into Non-Qualified Stock Options (NSOs), which have worse tax treatment. But I think the real reason is that founders and investors want to get the shares back in the pool rather than have someone who isn’t working at the company on the cap table. Not only does an employee have to pay for the shares, they likely have to pay taxes on the gain of the stock’s value as well. Unsurprisingly, only a small fraction of vested options get exercised. I was recently discussing this with the CEO of a Series C-stage company. In conjunction with some layoffs, he wanted to extend the option exercise window employees and was getting push-back from the board. It wasn’t surprising to me that the board member from an old school firm was not receptive to being generous with soon-to-be-former employees. Other firms may argue that extending the option exercise window favors former employees at the expense of current ones, which strikes me as a backward way of looking at the situation rather than a forward-looking one.
Shrinking option pools
When I started working in venture in 2006, the standard option pool for an early stage company was 15 percent. Now, more than a decade later, we frequently have debates with companies over whether or not a 5 percent option pool is sufficient. (It’s not.) Based on recent analysis of our portfolio companies, Series Seed rounds typically include an option pool of 7 to 10 percent while Series A rounds generally have an option pool of 10 to 15 percent. Research from Carta cites slightly higher options pools, but generally supports the trend that option pool sizes have declined by about 5 percent. However, a more recent Carta study indicates that this pattern may have begun slowing reversing course in the last part of the most recent economic cycle.
Clearly, founders have figured out that if the option pool is smaller, they take less dilution in a priced round. And, if they run out of room in the pool, they can always just ask the board to expand the option pool and force the investors to share in the dilution.
Treating employees as owners and contributors who have earned their equity will pay off in the long run even after those employees have left the company.
How to Swing The Pendulum Back:
Regular liquidity events
At a time when the company doesn’t need capital but has interested investors, offer liquidity opportunities to rank and file employees. This allows them to afford home ownership, pay taxes or exercise their stock options. Better yet, waive transfer restrictions and rely on the right-of-first-refusal to let employees sell their stock in between liquidity events. Companies like Palantir have a much more permissive view of what employees are permitted to do with their earnings and have been excellent at recruiting top talent. Others, like SpaceX, periodically offer employees the opportunity to sell shares in company-facilitated offerings.
Eliminate vesting cliffs
The argument I hear in favor of using a vesting cliff is that the company is given an opportunity to see if their employee is going to work out. However, if equity is truly compensation, then the employee has earned it and should not be deprived of the fruits of her labor. Even shortening the cliff to six months would be a step in the right direction.
Longer option exercise periods
Be like Flexport and these 90 other companies. Take the pressure off of employees and give them ten years to exercise their stock options.
Offer early exercise
It requires a little more bookkeeping on the part of the company, but letting employees exercise shares early reduces the employee’s out of pocket costs and starts the capital gains clock ticking. Who wouldn’t want that?
Hiring is the single biggest problem most companies face. Even in the current COVID market, where recruiting may not be as competitive, creating compensation structures that favor employees demonstrates that a company values its people. This will always be a huge competitive advantage and will support recruiting efforts throughout the organization.