Designing Incentive Equity Programs

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Equity Drove Wealth for the Last 50 Years

The software industry made stock options famous. Three of the world’s five richest people — Bill Gates, Larry Ellison and Mark Zuckerberg — were tech company founders, but it’s not only the founders who made out. The New York Times estimates that more than 1,000 Google employees made more than $5 million each from their equity compensation. And that was in 2007. At the time of its IPO in 2012, Facebook created more [stock-option?] billionaires than any other company in history.

Today, nearly every high-tech, high-growth company issues equity incentive compensation to their employees in the form of incentive stock options (ISOs) or restricted stock units (RSUs). Options, at some level, align all employees’ interest at the company. Everybody wins if market cap — and therefore share prices — go up. But that’s where the similarities stop. Equity plans are complex, and there are long-term implications you need to consider when you set them up.

When your company is private, stock options seem cheap relative to compensating employees with cash. Because they are multi-year incentives requiring vesting, stock options also help with employee retention. Luckily, boards and investors know that giving away part of the company has a true cost: dilution. You end up owning less of the company, but ideally that’s in the service of inspiring people to work harder and creating a more valuable company.

Size Matters

So, you have decided to have an incentive equity plan! (And, frankly, you need one if you plan to hire anyone.) First, you’ll need to determine how much of the company to distribute to your employees. A good rule of thumb for a young company that plans to grow fast is to reserve 20 percent for the option plan for your first institutional round. Expect that to last about four years.

When that runs out, it is less common to renew another 20 percent — that’s a lot of dilution for your board to stomach in one go. A more tactical approach is to approve one year at a time, but with the numbers staying more or less the same, leading to a 4- to 5-percent increase in the option pool per year. These are rules of thumb. If you are having a peak year in terms of hiring, you might break right through this. Conversely, if you are able to attract and retain talent for less, nobody will force you to spend everything in your pool. Nor should you want to. Dilution hits all equity holders equally, including founders and management.

There appears to be a trend towards giving out less equity after you go public, with some companies like Microsoft (MSFT) and Microstrategy (MSTR) abandoning the practice altogether. This is driven by two factors:

  • Institutional Shareholder Services, a group that rates companies on governance and other attributes, doesn’t like it. Investors often consult them before shareholder votes, or sometimes even before investing.
  • At a certain point in a company’s life, rapid increases in equity are less common; stock options at that point are not as motivating.

If You Don’t Get It, You Don’t Get It

Of course equity distribution programs for employees run the gamut, but the two dominant tendencies are to go wide or to give a highly concentrated distribution of options.

The theory that employees will care more about the company and work harder when they own part of it logically leads to a wide distribution of equity grants. But, widely distributing equity takes a real toll in terms of dilution. Some companies find that at lower levels in the organization, equity doesn’t move the needle on employee motivation. These employees might look at their equity as effectively a raffle ticket rather than compensation. Management, on the other hand, is often very focused on their grants. Equity, can be a much longer discussion during management hiring and review cycles than cash compensation.

An Emerging Distribution Trend

We have spoken to many current and former CEOs and CFOs [Note to self: decide on voice of “we”; get some one-line anecdotes in here. ] about wide versus concentrated equity grants. While many initially thought they wanted to give each employee a part of the upside, the challenges of having two employee populations who value equity differently led one to modify distribution slightly, favoring those who value it the most. And this is the method we currently prefer here in the monkey cage. [anecdote, use names, co.]

By doing a wide but more modest distribution at all levels of the company, you accomplish the alignment objective. It also works as a branding opportunity: Now we’re all owners. But when you concentrate grants at higher levels in the management pyramid, you are spending your precious equity where it is likely to be most effective.

Vesting, Cliffs and Grant Frequency

Beyond pool size and how widely you grant equity among your employee base, the most important parameters, are frequency of grants and vesting schedules. These are interlinked and must be seen in context.

We’ll look at the easiest one first. Vesting refers to when ownership of equity transfer from company to the employee. Traditionally an employee would get a grant when being hired, and it would vest over four years, in four equal cliffs at the end of each year. Over time, vesting has become more employee friendly with a majority of private company plans utilizing a cliff for the first year of hire, and vesting monthly thereafter. Some more aggressive plans start the monthly vesting immediately as new as employment commences. Detractors from this approach argue that you need employees to stay with the company for at least a year in order to generate value.

Hanging Off the Edge of a Cliff

The right vesting schedule has the potential to both reduce attrition and lower the cost of your equity program. The main parameters are length and frequency of vesting. The standard is still four years, but we have seen both three and five years used. The longer the schedule, the more retentive the effect, in theory. However, giving out the same amount of equity to last for more years can easily backfire. To counter this, you should calculate that the employee has the right target compensation per year when giving the grant.

The argument for cliff vesting (as opposed to monthly), is that equity is meant to be a long term incentive, and not just part of your regular salary. The theory is that if you have meaningful equity still outstanding you will wait for at least the next vesting period before leaving your company. The other side of this argument is that it may lead to massive attrition around vesting points. Experience does not appear to prove this out, however, as it is rare that job opportunities neatly line up with people’s vesting schedules. Some companies have taken this concept even further. Not only did one company we know have all annual cliffs, it went from the usual 25/25/25/25 vesting distribution, to zero in the first year, 50% at the end of the second year, and then 25/25 for the last two years. At the time of this writing, that same company had moved to vesting new employees nothing until the end of the third employment year, when they would vest 75% of their grant. The success of this model is measured in terms of low attrition, since people tend not to want to leave before getting any equity, and for those who do, and decreased equity burn for the company. Since the average startup employee only stays for around two years, the impact on dilution can be significant over time. This may work if you can attract employees with other means, but it is widely seen as employee unfriendly, and may turn off more sophisticated candidates.

What’s the Frequency, Kenneth?

The most poorly understood aspect of designing an equity plan is probably the frequency with which you make equity grants. The traditional model is to give a four-year grant upon hiring and then re-up employees at the end of the original grant term. Retentive effects are strongest at the time of hire and reduce over time. More mature companies [examples?] might give a lower upfront grant with refresh grants each subsequent year, all with the same-length vesting period. The annual refresh approach creates a strong retentive effect — any employee who quits will leave significant equity on the table — but using a low upfront grant can make it hard to attract top talent.

Andy Rachleff co-founded Benchmark Capital and is now the CEO of Wealthfront, a wealth management firm. Over time, Rachleff has arrived at a model where new employees get the traditional four-year ISO grant at hire, but after two and a half years, they receive refresh grants equal to 25 percent of the grant a new hire in the same position would get. The idea here is to be able to make grants at market, ahead of full vesting, when an employee might be tempted to start looking for other opportunities. For the company, of course, this model leads to a slightly higher burn rate than re-upping the employee after four years.

How to get implementation right

While there are a number of additional considerations (which will be covered below), the rug that brings it all together, is the equity budget. Much like a regular budget, you set this once per year, and you watch to see that you are one track during the year. You can download a simple model of how to do this at the top of this page. (should we hotlink from here as well?)

Essentially you need to make room in your equity for five types of grants:

  • New Hire Grants is what you give new employees and is set by what the market requires.
  • Promotion Grants is given to people upon promotion and is usually the difference between an employee’s current base grant and what she would have been awarded were she hired into the new role.
  • Performance Based Grants is given for truly remarkable performance and should be reserved for your top performers. This is not one of those things where everybody gets a medal, or you will quickly run out of equity. Giving this to around 10% of the employee base, is a useful rule of thumb.
  • Refresh Grants are grants given employees to maintain the retentive effect of stock options over time. As discussed above, a good model is to start these 2.5 years into a person’s employment and then continue every year thereafter.
  • Other Grants include grants you make to partners, customers, board of directors and advisory boards. This is usually the smallest part of your budget.

The sum of these types of grants make up your gross equity burn. After factoring in forfeitures (i.e., shares going back to the pool because of employees leaving prior to vesting, or just not exercising) you get your net burn, which is what you need to make sure you can cover with your current pool, or you will need to expand the total number available.


Types of Incentive Stock

Incentive Stock Options (ISOs): For years, incentive stock programs only came in the form of stock options. They remain the most common type. These securities vest over time, and they come with a strike price. The strike price is what the employee has to pay in order to exercise the option and take possession of the underlying shares. For your company to receive favorable tax treatment — and avoid accounting nightmares — these have to be issued with a strike price equal to or above fair market value at the time they are granted.
Non-qualified Stock Options (NQSOs): Because only employees can receive ISOs, granting NQSOs for non-employees, such as contractors, can be useful. Whereas ISOs are qualified stock options, NQSOs do not receive preferential tax treatment. In recent years, some companies [list a few] have moved exclusively to granting NQSOs because it lowers their tax burden. Of course, it increases the employee’s tax obligation — sometimes significantly so — so this is uncommon.
Restricted Stock Units (RSUs): Grants with no strike price are RSUs, and they usually vest like ISOs. Because the shares have no strike price — they are simply given to employees when they vest — RSUs tend to be popular with employees. For the same reason, they are more expensive for your company. Use them with caution. Not only do you fail to get the strike price back when employees exercise the options, forfeiture rates will be much lower because employees never have to make purchasing decisions. Although the vesting of RSUs is usually aligned with an employee’s hiring or promotion date, to simplify tax accounting (as described below in RMW:WHAT section), companies typically make all employees’ RSUs vest on the same date(s), and not more frequently than two to four times per year, which effectively imposes, at best, quarterly vesting.

ISOs and NQSOs vs. RSUs

After two decades of doing this, we, the monkeys,[RMW:decide narrator, be consistent] think NQSOs are best left to non-employees, and companies ought to focus on ISOs until relatively close to a liquidity event. High strike prices and employee sentiment may force a change over to NQSOs for employees sooner, but by and large — and for all sorts of reasons outlined in this article — both ISOs and NQSOs are easier to manage than RSUs, which come with complex taxation issues, cash implications that aren’t favorable to your company, and lower forfeiture rates.

A large majority of companies swap ISOs for RSUs at a rate lower than 1:1. While this is a solvable equation using the Black-Scholes formula, we typically have seen between 2:1 and 3:1, and, in a majority of cases, without much academic backup.

Even for companies where RSUs are the norm, the board often likes to see a split between RSUs and ISOs for executive management, in order to keep interests aligned. This split might continue further down the management levels, as well, although companies differ widely in this regard.

Option Pricing (and the Spectre of Enron)

Pricing of equity is vitally important. It not only defines the cost to you of your incentive, it pegs the starting point from which the employee’s eventual benefit will be determined. [TK: Minor thing: I liked word “peg” but felt the phrase wasn’t complete. Pricing of equity doesn’t peg the benefit so much as it pegs the starting point of the benefit, right? Pls check my language.] Hopefully, the underlying shares in ISOs increase beyond their strike price, and the employee buys them for less than their eventual market value. Of course, for reasons readily apparent, the IRS takes note. Options generate wealth for employees, and the IRS’s stance is they should be taxed, right along with salaries and other tangible income.

Section 409A of the Internal Revenue Code originated from the desire to curb certain practices around deferred compensation, such as Enron-style acceleration. Before Enron went bankrupt in 2001, its executives accelerated access to their deferred compensation, arguably when they knew where the company was headed but before rank-and-file employees did. We all know how this ended, but for small, private companies, Section 409A is the gift that keeps on giving from that debacle. Among other things, this rule, which took effect in 2006, requires private companies to get an outside opinion on how to set fair market value (FMV) for incentive equity. [TK: Just want to be clear here: The outside opinion is on how to set the FMV, not on what the FMV is?]

Easy for public companies — they merely look to the stock market — setting FMV for private companies has always been something of a dark art. Critics say it still is. The bottom line is the IRS doesn’t want you setting the strike price for ISOs below market, thereby give employees in-the-money options. As a hiring tool, of course, you want equity priced as low as possible to offer the best value for employees. And despite Section 409A, companies effectively can still do below FMV grants through workarounds, but the accounting implications of issuing those below market options are so onerous as to make it not worth considering. It’s also akin to giving employees cash, which has tangible tax consequences for them at a point when it’s unlikely they can sell the stock. [TK: Check all wording in last half of graf. I wanted to shorten it a bit and wade out of details of the topic yet without losing main info. Perhaps introduced inaccuracy.]

For RSUs, Section 409A doesn’t govern the strike price — there is none — but instead has a direct effect [what is the nature of this direct effect?] on how your employees are taxed. Mess this up [how would you mess it up?] , and you will be sorry – your employees will make sure of it. [TK: I don’t think you need great detail here, but a few words about how 409A affects taxes and how you could “mess it up”.]

A cotton industry of companies now exists offering 409A valuations of your common stock. Their charges range from $5,000 to $20,000 annually, usually for four updates. You can squeak by the IRS regulations with two reports annually, but four would be wise.

Although the work they do is fairly standard, engage with the valuation professionals you choose to ensure the right outcome. Sending off the data they request and simply accepting what comes back won’t lead to an ideal outcome. As discussed, you want to price incentive options low to make them attractive to your employees. The valuation professionals, on the other hand, are driven not to price equity below market because of the accounting and tax implications. For these reasons, and because they don’t know your company-specific facts well, the professionals’ first draft tends to come back high. Bear in mind the following:

  1. The price of preferred stock that your investors paid at the last round is just a starting point, and a high one. For early stage common stock, the discount to preferred should be greater than 90 percent. As you get closer to a liquidity event, your common stock should be priced more similarly to preferred, adjusted for any conversion disparity.
  2. When you establish a price for common stock, think about including some discounts:
    • Minority discount: With only a small percentage of ownership, employees who hold common stock have few ways of effecting shareholder votes.
    • Marketability discount: It is very hard for a common stockholder to sell their shares since they simply do not have access to the kind of information that buyers of non-public equities need access to in order to set a fair price.
    • Liquidity discount: Even if a company sells for hundreds of millions of dollars, sometimes common shareholders receive nothing. {get flashy example here.} This is because VCs often have the right to get their money back (or multiples thereof) before anything is distributed to common.
    • Lack of rights: As a security, a preferred share comes with more rights than common does. It can be hard to put a value on this, but there mere fact that they exist, imply that they have value.
  3. Strike price for common tend to have temporal peaks around financing event and go down afterwards. This is because valuation methodologies weigh recent events more heavily than they would once time passes by.

Bottom line: Get a 409A valuation before issuing incentive equity, and make sure pricing is done right.

Exercise and forfeiture

Normally, options can be exercised as soon as they vest. Whether it’s in your employee’s best interest to do so depends on many factors. The earlier she exercises the options, the sooner the clock starts on capital gains. She needs to hold shares for at least a year after exercising them in order not to be charged income tax on the gain. Exercising early also minimizes the amount of alternative minumum tax she has to pay. To counter this argument, realists point out that some 90% of startups fail, and she may lose what she paid to exercise her options. Hence it becomes a tradeoff between risking the cost of exercise versus potentially paying less in taxes.

Forfeiture sounds a little scary. Here forfeiture refers to incentive stock an employee is giving up when leaving the company. Either because she is leaving before all her stock has vested, or because she chooses not to exercise some (or all) of her vested stock upon leaving. By law, you have to exercise your stock option prior to 90 after leaving your company. However, most companies set a shorter window, typically 30 or 60 days. It is important that both employer and employees are aware of these rules, as any excess shares go back into the option pool, and can be regranted. By and large, the higher the strike price, the more stock goes unexercised. This helps your equity burn rate, of course, but some find it undesirable that people “lose” their sweat equity. One company that has taken this to an extreme, is Eventbrite. Founder duo Julia and Kevin Hartz allow their employees to exercise vested options for up to 10 years after being issued, irrespective of whether recipients are still with the company. Great benefit for employees, but it does drive up the cost of your equity program (and from an accounting perspective, you’ll have outstanding liabilities for a long time).

Taxation with representation ain’t so hot either

George Harrison wrote the Beatles song “Taxman” after the band had already made it, and their success landed them in the then current “super-tax” rate of 95 percent in the United Kingdom. Most people don’t face these issues, of course, but the IRS considers incentive equity as gains stemming from people’s employment (and hence taxable).

The biggest difference between ISOs and RSUs is that you don’t have to pay a strike price for RSUs. Due to this, however, the full value of RSUs are considered income when they vest. Technically, you don’t have to pay taxes on your options until after you have exercised and sold them again. Technically, that is. There is a real tradeoff here, and it ought to be considered at the point of issuing the grants, not when you get the tax bill.

Taxing of ISOs: Since stock options are issued with a strike price equal to fair market value, there is no taxable gain to the employee at the time of issue. (You can see why you don’t want to issue options below FMV.) Note that while the IRS doesn’t really tax options until you sell the underlying shares at a gain, in most cases employees are likely to trigger the alternative minimum tax, or AMT. For all intents and purposes, this is calculated as regular income tax on the difference between strike and FMV at the time of exercise. When the employee actually sells the shares again, she pays capital gains on the delta between strike and sale price, provided they have held the shares for over a year. Any AMT tax paid should then be credited against the the cap gains taxes due. (For NQSOs, this credit generally does not happen.) This is when normal folk start having their taxes prepared by a professional

Taxing of RSUs: On the surface, RSUs appear more attractive, because you don’t have to pay to exercise them. However, this also means that the IRS will look at the value of the shares as they vest – and tax them at the holder’s marginal income tax rate. What’s more, the employer is responsible for income tax withholding. As a private company, this creates an issue because the tax due upon vesting can be many times a person’s paycheck, without the ability to sell. Most companies “net-vest,” which means they withhold an amount of shares deemed to be enough to pay the employee’s income tax. Great for the employee, but now the tax burden is shifted to the employer – and the IRS still prefers payment in cold hard cash. For startups, one way to delay help cash flows, is to make vesting contingent on a liquidity event (such as an IPO), so that there will be funds available when taxes are due. This sounds like an attractive option, still, it can be challenging to explain employees that their equity is vested, but not. For public companies selling off shares withheld to pay the IRS is compelling, yet a majority actually uses their own cash on hand and takes the shares back, retiring them as treasury shares. This effectively becomes a share buyback program, which shareholders typically love for its anti-dilutive effect.

Executive privilege

There are a few additional bells and whistles commonly seen in private companies, but rarely with a wide distribution. We will cover Acceleration and 83B elections below.
Acceleration is when you let employees speed up their vesting pattern, typically in conjunction with the company being acquired. The two main forms are Single and Double Trigger. Single means that the acceleration is triggered by a simple event, such as an acquisition, and Double means it needs to be coupled with another qualified event, normally termination of employment. Employees widely favor Single, whereas investors favor Double. The employees’ argument is that it will incentivize them to actually get the acquisition done. From the investors’ side you’ll hear that if the company is acquired and you still have your salary and your equity, there is no reason to compensate for any assumed loss (and you were already willing to take this job at your current comp level). In addition, most acquisitions happen at least partially for the talent in the company, and any acceleration is therefore a double whammy: The acquirers lose the talent, and they have to pay the cost of the extra shares vesting. This could turn some acquirers away.

We have seen some forms of acceleration covering the entire employee pool, but that is extremely uncommon. Acceleration is a very costly tool, and is therefore typically reserved for (parts of) management. While it is considered standard for Founders, CEOs and CFOs, it is not unusual to see this cover entire management teams, but then only for a double trigger event. Companies also differ in how much of unvested equity they accelerate.
An 83B Election refers to another arcane part of the Internal Revenue Code. While section 83 stipulates that holders of incentive equity do not need to recognize income – and therefore be taxed – until the shares vest, Section 83B, allows the holder to recognize the “income” upfront, before they vest. Since under normal (and successful) circumstances, equity will be worth less upfront than later on, this minimizes the immediate tax burden for the holder when she also often has no ability to sell the shares. For founders and early management employees, you would almost always want to do this, irrespective of whether the equity in question is treated as RSUs or ISOs. The upfront cost – either as tax on RSUs or exercise price on ISOs – is often negligible, whereas income and AMT tax can be substantial later, when the holder may not even have liquidity to service it. An 83B election must be made with the IRS within 60 days of the equity grant.

Don’t try this at home

It goes without saying that none of this is meant as either tax or legal advice. Consult your expensive, but qualified professional before getting yourself and all your employees in trouble. This is exactly what your over-priced, outside corporate counsel is there for. You will not save money in the long run by doing this in house, however, you may be prosecuted for securities fraud.

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