Thursday May 24, 2012 by Andy Palmer - Serial Entrepreneur, Advisor, & Investor
An Alternate Approach
In my last post, I wrote about how important it is for founders to take a proactive and decisive approach to crafting their ownership models – to the extent of being a control freak about it. Getting the correct ownership model in place up front is one of the more important decisions you will make as a founder, and it will guide you through key hiring decisions.
And it doesn't matter how many or how few employees are involved* – it's still important. Do you grant stock up front to new employees? Or do you delay the grants (either through vesting or follow-on grants) over some period of time? There are costs and benefits to various approaches, and many different mechanisms for executing any given approach. Having a great start-up lawyer is key: the best folks I've ever worked with are Mitch Zuklie at Orrick and Marc Dupre at Gunderson.
"Front-loading" stock options – granting large options up front to key employees – has been a popular approach in the past for many start-ups. But I've come to believe that a better approach is to give smaller stock grants up front (with relatively standard vesting of four years total with one-year cliff, then monthly for the last three years); followed by many small grants over time, at least annually but preferably every six months or so.
When you grant options in this way, you essentially create a "ladder" of stock vesting that helps ensure that the rate of vesting for any given highly valued employee is going up consistently during that employee's first five to ten years at your company.
Of course, you can always make exceptions, giving them a large up-front grant. However, I believe that such grants should be the significant exception rather than the rule.
Here's my rationale.
How It Works and Why
With a laddered approach, you're focusing on the RATE of vesting, not the size of the initial grants, to increase the likelihood of retaining superstars over time. Key employees who you want to reward and retain for the long haul enjoy an ever-increasing RATE of vesting: the number of options that vest each month or quarter after they pass their cliffs. This also has the benefit of minimizing the impact of bad hires, who – assuming you are doing your job – will leave the organization before they vest too much and/or will not receive follow-on grants.
The laddered approach has a powerful psychological impact on the employees. They're getting regular feedback on their performance. They FEEL appreciated on a regular basis and their efforts are recognized by the company through ownership, the most valuable form of compensation in mission-driven startups. The sacrifices they are making are often “unnatural acts” of saying no to family, friends and personal comfort in the interest of doing “whatever it takes” to make a company successful. Being recognized with more ownership over time, in my experience, means more to the average start-up employee than most investors can ever appreciate.
Another benefit of this approach is that it can protect you from a common pitfall: inadvertently selecting people who are great negotiators but perhaps not as good at actually doing the work and earning the stock. For example, sales-oriented people tend to view the negotiation as an end in itself, while engineers tend to view the work as what determines value and earns rewards. By appealing to mission-driven people who know that there is more ownership available to those who perform, you'll attract people who are confident and willing to prove themselves and for whom the mission of the company is enough to get them on-board initially.
This approach does have some downsides. It can require a lot of administrative support and careful expectation-management so that employees don't expect both frequent grants AND large grants regardless of company and individual performance.
Another potential downside is that the strike price of options or the purchase price of restricted stock increases over time. So, the weighted average price for the individual is higher – sometimes dramatically higher during the first five years of a new company’s life cycle. This can be especially hard if you are allowing your employees to exercise their stock early. However, I suspect that most companies would be more than willing to compensate for this by granting a larger quantity of stock for the ultra-high performers. It’s a net-positive-value decision to give top performers a disproportionate amount of stock. The basis for their retention compensation is that they create more value than other people. Therefore, locking them in with more stock is equivalent to fundamentally increasing the value of the stock.
Ultimately, I believe that this approach actually costs the company less in the end.
I believe that the practice of large initial stock grants is nothing more than an artifact – and one that doesn’t optimize growth for the company or the investors. Let’s bury this practice once and for all and use it only as an exception not a rule.
* Except of course for the extreme case where no one gets any ownership other than the founder. If you are looking for examples of those, there are plenty - for example, Kenan Systems and Ab Initio in Boston or Trilogy in Austin.
Andy Palmer is a serial entrepreneur, investor, and advisor to startups in the Boston area. You can find this blog post on Andy's blog post called The Fundable. You can also follow Andy on Twitter (@andyhpalmer) by clicking here.