Options: What your board members want to know and how not to keep employees waiting for options

Posted by Dave Broadwin on August 02, 2012

Option grants are usually a non-issue at the typical board meeting.  During the financial presentation the CFO flashes a slide with the following information:

  • Size of the option pool
  • Number of options that have been granted
  • Number of options remaining and available for future grant
  • Names of employees and numbers of options proposed to be granted at the particular meeting, if any
  • Exercise price

The directors often have a couple of questions about who is getting how many and why and whether the remaining options will be sufficient for planned hires etc.  After a brief discussion, the grants are approved.  Good housekeeping suggests that there be a brief presentation of the status of the option plan at each board meeting whether or not you are asking for specific grants – just to keep the board current.

BTW: after the approval, the CFO typically completes the actual option grant forms, they are then signed by the CEO (sometimes the CFO) and distributed to the employees.

Sounds simple, until you don’t do it, and you want to ask for approval of option grants.

If you don’t do it (and by “it” I mean prepare a slide with all the relevant information) regularly (and by “regularly”, I mean at each board meeting), an alert board member is likely to be annoyed and have a lot of questions, when you do ask for approval of grants.  While it may seem like a small amount of information to convey and absorb to you, this is likely to be because you have thought about it in connection with determining what grants to ask for.  To your board member it is likely a matter of first (or at least not recent) impression.  No matter how much you try to explain it, the director is likely to ask for better information, time to consider and then decide to take it up at the next meeting.

You, of course, will be embarrassed because you will have promised grants to various people and will then have to explain that they won’t get the grants until the next board meeting.

Before you get steamed at the board member, here are a few things that are likely to be running through his or her mind (remember they are not on top of the facts because you have not been reminding them regularly):

  • What percentage of the fully diluted is the pool?
  • Has the percentage of the fully diluted represented by the pool changed due to recent issuances?
  • What is the exercise price?
  • Do we need a 409(A) valuation?  Do we need an update of our old 409(A) valuation?
  • How much of the option pool has been used up?
  • What planned hires do we have, and how many options will we need for them?
  • Will we have to increase the pool, and how much will that dilute the investors?
  • Is there acceleration on an exit? 
  • Is there a double trigger?
  • Why am I being put in the position of being the bad guy and delaying grants to employees when the CFO should have a slide with all this in the board package?

These and other questions are likely to come at you rapid fire.  No matter how crisp your answers, at some point your director is going to say something along the lines of “I am not prepared to decide on this now, let’s put it over to our next meeting.” 

Once those words are spoken, the likelihood of anyone saying, “nope, we have to decide now…” is vanishingly small.  Furthermore, can you imagine a director’s reaction if you said that? 

So, guess what, your employees are going to be waiting until the next board meeting.

409A Déjà vu all over again

Posted by Dave Broadwin on June 19, 2012

With apologies to my favorite American philosoper, last week I participated as a panelist in a webinar on the topic of 409A.  The panel was sponsored by the good folks at Corporate Focus (which provides a great service that many law firms and companies use) for tracking stock and options.  They asked me along with Channing Hamlet from the appraisal firm of Cabrillo Advisors and Ed Sullivan from KPMG to talk briefly on a couple of 409A topics.  In addition, there was some Q and A at the end.  Below is a video of the webinar. 

Aside from yet again reviewing the significance of 409A and why startups should care about it, this webinar brought together a variety of perspectives on 409A in one place.  So, for example, by listening to it you can get a good sense of how the apraisal process works, how often you have to do it and so on. 

My favorite moment came in the Q&A when someone asked what to do if they had been issuing large numbers of options with exercise prices far below market over long periods of time.  I suspect that this situation may not be so uncommon.

Anyway here is the video:

Advice about Advisory Boards

Posted by Dave Broadwin on April 29, 2012

The question that I most frequently get asked about advisory boards is:  “How much equity should I give to a member of my advisory board?”  The answer is very little, almost certainly less than the entrepreneur is thinking about.  Perhaps some numbers would be useful here.  How about .1% (that is a tenth of a percent) to perhaps .5% -- depending upon the value to be provided.  By the way there should be vesting involved.  The vesting period should be long enough to cover the period in which you expect to be getting value from the advisor.

Having now answered (to the extent I am comfortable doing so in the absence of any specific knowledge or facts of any particular case) the only question any client ever asks about advisory boards, I hasten to note that there are a lot of other – far far better – questions that could be asked about advisory boards.  Here are a couple:  What value can I reasonably expect from a member of my advisory board?  How do I get that value?  Why do I need an advisory board at all?  How do I find good advisors?

I don’t have any objective or quantifiable information around whether and how much value start-ups derive from their advisory boards.  My gut sense, based only on my law practice, is not much.  Mostly, what start-ups get is the opportunity to name a few luminaries on a slide towards the back of their deck.  The second thing they probably get is some introductions, probably to investors. 

I am sure there are some companies and entrepreneurs that have benefited greatly from advisory boards, but I have to believe this is a small number.  Below are a couple of links to blog posts on the subject of advisory boards.  The one from venture hacks seems to me to be particularly good in that it covers a lot more than just compensation, although it also covers comp.

Venture Hacks “Everything you ever wanted to know about advisors”

Ask the VC “Are Advisory Boards Helpful?”

Ask the VC “Advisory Board Compensation”

 

409A Option Pricing Redux

Posted by Dave Broadwin on January 09, 2012

Last week I had a conversation with an entrepreneur who was confused about option pricing, and no matter how many times I tried to explain it, he never seemed to get his head around it.  Now, there may be a psychological explanation for his inability to understand, because he clearly wanted to hear a particular answer, and it was not what I was telling him.  Nonetheless, option pricing is a topic that comes up all the time in the representation of early stage companies and, while I have written about it before, it is worth one more post.

What is 409A and why do you care?

409A is a section of the Internal Revenue Code that governs the tax treatment of certain options.  409A provides that an option either (1) be an option for common stock of the employer and have a per share exercise price on the date of the grant equal to or greater than the fair market value of a share of common or (2) if the option has an exercise price of less than the fair market value of a share of common stock the recipient and the issuing company suffer some pretty draconian tax consequences.  (There are other ways to comply, but relate to less usual situations, such as options that are only exercisable on a liquidity event, and I am not going into that level of detail here and now.)

What are the draconian tax consequences?

There are three particularly nasty tax consequences:  (1) The recipient of the option will have income equal to the difference between the fair market value of a share of common stock and the exercise price of the option multiplied by the number of options, at the time the option vests, even if the recipient does not exercise the option.  (2) The recipient will get to pay a surtax of 20% over and above his or her normal income tax on the option related income.  (3) For each year for which the option remains outstanding, the recipient will suffer the same nasty tax consequences with respect to any increase in the value of the common stock. 

Why on earth would the IRS create such a rule?

Consider what could happen if the issuing company were publicly traded and was issuing options with below marked exercise prices to its execs.  Need I say more?  Unfortunately, 409A applies to all companies – not solely public ones.

What can I do to avoid the bad tax consequence?

Issue your options with an exercise price equal to or greater than the fair market value of the underlying shares.

How do I know what the fair market value of a share of my privately held technology start-up is?

Here are some ways to price your options:

(1) You can take a guess at the fair market value.  If you guess wrong you are toast.  And, by the way, your guess will be judged with 20/20 hindsight by the IRS.  So, that does not seem like a good solution.

(2) If there is a recent actual arms-length transaction in which common stock was sold, then you have price.  Note that I said “actual,” “recent,” and “arms-length.”  The fact that your lawyer took a few shares a year ago in consideration of an old invoice won’t cut it. 

(3) If you have a financially sophisticated person on your board (or as your CFO), and your company has been in business fewer than 10 years, 409A provides that such person can perform a valuation. 

(4) You can pay an outside appraiser to perform a valuation.   Most (all?), of my clients who have professional money invested in them end up doing this.  It is a toll and it is unfortunate that you have this cost, but that is you tax dollars at work. 

Like my entrepreneur friend, you can want to price options at $.03 but if you sold common stock last week  in an arms-length transaction for $.30 per share, don’t do it.

Options: How long a period for vesting

Posted by Dave Broadwin on October 19, 2010

I have not written about options in a while, but a post by Fred Wilson has led me to want to make a couple of points.  Before I start in on the points I want to make, in fairness to Fred Wilson, as he himself points out, he has barely dipped his toes into this topic and he plans many more posts. 

With respect to vesting, Fred has the following to say, “Vesting usually happens over a four year term, but some companies do use three year vesting.”  It is true that in the case of venture funded companies the “norm” is four year vesting with a one year cliff, but I rarely see three year vesting.  (Right now, I don’t recall ever seeing it in the context of a “normal” option grant for a venture financed company.)  I don’t mean to quibble, by I have noticed a trend to the other end.  There are at least a couple of VCs (one in Boston and one in Silicon Valley) that I know use five year vesting with a one year cliff.  Anecdotal information suggests that this practice is gaining ground. 

The reason for this trend, if it is a trend, is that VCs want to more precisely align the payoff to the option holder with the liquidity event (exit) for the VC.  As it turns out, many very high quality venture funds have average holding periods for investments of north of 8 years.  That is to say that, on average, it can be 8 years (or more) from the closing of the first investment to the exit.  During that period, many employees can vest large piles of options, and (at least in theory, and to be fair, often in practice) leave the company, exercise their options and take their talents elsewhere.  Top re-incentivize these employees, it may become necessary to “reload” option packages from time to time.  This practice, of course, can be expensive.  And, if the employee leaves and has to be replaced, the replacement will need an option package.

I understand this thinking, but I am not a big fan of five year vesting.  Although, I don’t think there is a principled reason to pick 3, 4 or 5 (or any other time frame for that matter), here are is a reason why I don’t like it.  First, in the tech world five years is an eternity – hell four years is an eternity.  It makes the brass ring harder to see and less tangible.  In effect it diminishes the incentive value. 

Many employees are great for different stages of a company’s development.  So, the guy who did product development at the start and was great with a team of two engineers can’t run a team of twenty.  He added great value for a period in the company’s development and then had to be replaced.  Only a few employees will really make every transition (admittedly some will). 

The compensation, including the incentive compensation, needs to dovetail with the expected performance not with the VC investment horizon.  (Just to make an exaggerated point, if vesting were to be keyed to the investment horizon, then the early employees might be looking at 8 year vesting and the later ones 2 year vesting.)  I can hear VCs saying we expect everyone to grow with the company etc. anyway how do we know we only want Harry for four years when we hire him but we want Sally for five?  What signal would varying vesting schedules send?  And so on.  We need a one size fits all solution…

So why 4 years?  Well, this amount of time seems to represent a compromise of sorts between wanting the liquidity to be consistent with liquidity and wanting it to be consistent with the relevant term of the services provided.  It seems to work in most cases.  So, before you buck the trend, you should have a good reason because if you go for a longer period you will undermine the value of your options to your employees and will make it harder to hire and keep them.  If you go for too short a period, you run the risk of undermining the incentive to stay.

The Time Value of Vesting Options

Posted by Dave Broadwin on June 01, 2010

 Jeff Bussgang has a recent post on why vesting schedules should anticipate the time to exit (the gist of it is that vesting should align VC and employee expectations). In his post he notes that time to exit these days is 6 to 8 years.   His fund is likely performing better than the industry because it is more like 8 than like 6.

In response to a comment from me the effect that vesting should be more keyed around expected milestones than arbitrary time frames, he notes that this is what employees get a salary for. Here is the quote:

Employees get paid salaries to deliver results and cash or stock bonuses help focus on milestones. Stock options are really about earning into equity ownership over time. That equity value is only really realized at exit.

I gave this some thought and I agree and disagree. Options, like money and everything else, have a time value and are only motivating if the option holder really thinks she has a decent chance of actually realizing on their value in this lifetime.

Here is a comment to Jeff Busgang’s post from Healy Jones,

Jeff, this is crazy talk! Keep your hands off my vesting schedule; it seems really long to me as is. ;)

Many of the early employees are not likely to be there in 6, let alone 8, years. (No doubt some will.) Many people who are highly suited for the early stage environment and can (and do) make significant contributions are not well suited for the middle or later stage environments.   A classic example is the first CEO. Let’s be honest, a lot of these folks make a real contribution then get moved on. 

Another point is that many people take employment with start-ups for the equity and not for the salary. My sense is that start-ups don’t pay what IBM or Google pay for the same resumes. The equity is an important (perhaps critical) part of the compensation for the day to day work (for which they are being underpaid in the sense that they could get more cash from Microsoft).

So, my point is that pure time based vesting (whether it is slow or fast) does not make sense because it does not compensate for the work done and the contribution made. I have noted this before from the point of view of founders with co-founders or employees that do not perform.

Milestone vesting may not make sense because milestones can sometimes be hard to define and they can be all over the place. 

So, perhaps some amount of time that makes sense in terms of the horizon in which the employee is expected to make a material contribution is a sensible compromise. Whether that should be 2 years, 4 years or 8 years, perhaps depends. 

Jeff is probably right to point out that the industry seems to have settled on 4 because it reflected some sense of historical time to exit.  That does not mean that we have to live with the logic and change the time frames. 

I work with a lot of very early stage companies and as among founder and very early contributors the vesting time frames vary dramatically. Very short time frames (such as one year or even less) and milestone vesting is common. The reason for this is the one I originally gave. Very early stage companies need to get work done, they can’t pay dollars so they pay equity. In this situation, vesting has to make sense in terms of expected contribution. When the contribution is made, you get your stock. 

If you want to hire W2 employees (people looking to work for a salary) and you want to keep them around, pay the salaries, provide the benefits, and vest the options at a slow rate because the options will be one more good benefit, like a 401K.

Many start-ups would like to be at the stage where this is the need. Unfortunately, the nature of the animal is that there are a lot of other phases you have to go through to get to this place. Vesting is one tool you can use to attract people to work for you for less cash than it might otherwise take. Vesting has a time value. The longer it takes the lower the value to the employee and therefore the lower value options have as a form of currency.

The Options for Options

Posted by Dave Broadwin on February 04, 2010

Sim Simeonov has a nice post on the subject of what is the best option vesting schedule. Options are a topic that has received a lot of attention in the blogosphere. A while back there was a lengthy discussion of options on Fred Wilson’s blog that, as I recall revolved around the need to think of option grants as percentages of the equity of the issuer (rather than in numbers of shares.  The EEC blog has many posts on options (and the related topic of restricted stock). All these posts tend to focus on some discrete aspect of options that came up in the author’s business. For a more general discussion, you can go to the Emerging Enterprise Center web site under "Ask the Start-up Lawyer." There you will find a general overview of the basics.

Startup Tools from Fastignite

Posted by Dave Broadwin on November 16, 2009

For those of you who know Sim Simeonov, you won’t be surprised or disappointed. He has developed and posed on his site, fastignite.com , a set of start-up tools together with commentary. The tools are good; the commentary is better. The initial set of tools covers (1) calculating true pre-money valuation, (2) getting a better Series A deal, (3) a vesting calculator for options and restricted stock, and (4) option exercise and sale.

With respect to the true pre and post money valuation, Sim points out that Fred Wilson has an insightful post on this topic. I think I agree with what Sim and Fred say on the subject, but I also think it sounds more ominous than it is. Keep in mind that the investor is assuming you will have to spend equity to attract talent. This is analogous to having to spend money for capital expenditures. It has to be a budgeted cost and has to be "in the mix" when you negotiate your deal. Your investor will not overlook this "cost." It will be built into the investor’s valuation assumptions. You just need to look at it the same way. A company that needs to spend money to acquire and IP license is not going to get the same valuation as one that does not (all other factors being equal).

Options and more options

Posted by Dave Broadwin on August 31, 2009

Here is an interesting post by Chris Dixon on options.  Well worth the read.  Having said that, I don't change my advice to the effect that the option grant (and the offer letter or whatever) needs to state the number of shares that can be acquired with the option.  If you want to elaborate on that and state that such number represents thus and such a percentage of the company's outstanding shares on a particular day -- fine.

Option and percents

Posted by Dave Broadwin on April 17, 2009

I am coming back to one of my personal bugbears. Clients seem to have a positive desire to express option grants in terms of a percentage of the company, as in "You will receive options to purchase 5% shares of Common Stock of the Company…" The problem is 5% of what? As of when? Usually clients resort the percentage expression precisely because there is some ambiguity in the cap table. This ambiguity is usually around some new money coming in. For example, is it to be 5% before or after the bridge note is converted? Before or after the next round of financing? Or what? I can testify that I have experience and employee pulling out such an offer letter years later at a multihundred million dollar exit and try to claim a percent rather than the number of options he actually had. Now, it did not take long to straighten him out, but do you really want to?

Option repricing

Posted by Dave Broadwin on March 25, 2009

Here is a link to an article about option repricing. Intel and other big public tech companies are doing it. Options are supposed to provide employees with an incentive to improve results and thereby increase stock value. In a sense, they align the employee interests with the stockholder interests. On the one hand, underwater option provide little (maybe no) incentive to employees. On the other hand, if you reprice downward when there is a market decline, you protect employees from the downside risk in a way that you don’t (and can’t) protect common stockholders. You can pick your poison.

Options and 409A -- Sometimes the law is an ass

Posted by Dave Broadwin on March 20, 2009

Sometimes practical reality and legal niceties collide like trains guided by Chas Adams. Here is a typical situation that must happen on a daily basis somewhere: I recently had a start up client call up and say that he wants to issue options to a new employee. The company was founded a couple of months ago, founder shares were issued, IP was contributed, options were offered, new guy was hired, client wants to know how to price the options. Enter Section 409A of the Internal Revenue Code which provides that the options must have an exercise price not less than the fair market value of the stock and fair market value be determined “by the reasonable application of a reasonable valuation method.”

Client: “OK, you’re my lawyer, how do I do that?”

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The Trouble with Options

Posted by Dave Broadwin on February 12, 2009

Everyone wants “incentive stock options” (as such term is defined in the Internal Revenue Code) as opposed to non-qualified options, because of the potential to capture capital gains tax treatment after the exercise of the incentive stock options and the eventual sale of the underlying stock. The option holder hopes to pay capital gains tax (as opposed to income tax) on the difference between the exercise price of the option and the price at which the underlying stock is eventually sold. So, if you have options to purchase 100,000 shares the Mighty Software Corporation with an exercise price of $.20 per share when Mighty is sold to Microsoft for $2.00 per share, your hope is to realize $180,000 of profit. If you are taxed at the current long term capital gains tax rate of 15% you would pay $27,000 in tax and keep $153,000. Compare this result to paying tax at the highest marginal rate of 35%. $180,000 multiplied by .35 is $63,000. In this scenario, you keep $117,000 (or $36,000 less than if you had paid tax at the capital gains rate). 

The dirty little secret of incentive stock options is that the holder must comply with a variety of requirements under the Internal Revenue Code to actually get capital gains treatment. Among these requirements, is a holding period requirement the effect of which is to prevent the option holder from getting capital gains treatment in almost all cases. The holding period requirement is that one must hold the stock obtained upon exercise an incentive stock option for a minimum of one year in order to get capital gains treatment. In fact, you have to hold the option and the stock for a combination of two years, but at least one year has to be after exercise.

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More on Restricted Stock and 83(b)

Posted by Dave Broadwin on December 15, 2008

I spend a lot of time with entrepreneurs explaining how restricted stock and Section 83(b) or the tax code work. It was the subject of a prior blog entry. However, it comes up so often and different people absorb the concept in different ways, so I thought it might be worth attacking again in a different way. Restricted stock can have some very material tax benefits when compared with options, especially in the early stages of any venture. So, here is how restricted stock works. I will compare it to options later.

You may want to incent employees by giving them stock. Here is an example. Easy Company decides to incentivize one of its employees by giving her a stake in the company. It then grants to Jane 100,000 shares (assume for the purposes of this example that the shares have a fair market value of $.01 per share). Two things follow. First, Jane owns the stock and, in our example, has no particular incentive to stay of the sort associated with vesting. Second, Jane has income equal to the value of the shares of stock she has been given. In this example she has income of $1,000. Easy Company must report (and withhold taxes for) this income on Jane’s Form W-2  for the year in which she was given the stock, and Jane must pay tax on that income. Now, $1,000 of income does not seem like much, but if the stock had a fair market value of $1.00 per share, Jane would have $100,000 of income on which she would owe tax. If her marginal tax rate is 40%, then she has to pay $40,000 of tax to the feds.

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