Employees like cash. Start-ups don’t have cash. How do we bridge the gap?
With cash-strapped start-ups funneling scarce capital into covering deficits and fueling growth, figuring out how to retain and fairly pay employees can feel Herculean. Stock Options are a key area that young companies turn to, and for good reason: they allow start-ups to hang on to the cash that otherwise might have to pay for bonuses, while also providing significant future upside to employees. When properly deployed, a good employee option plan both gives employees a reason to stay through their vesting period as well as providing “skin in the game” that aligns their interests with investor interests to see the equity value of the company grow.
But while both start-up management teams and start-up investors agree that stock options are an essential piece of the compensation puzzle, figuring out how to adequately dole them out is another question entirely. Big questions surround options, including how the vesting should be set up (Initial cliff? Annual vest? Quarterly vest? Refresh Grants?), how to price options, and how many shares to award.
Each of those questions is its own alligator to wrestle (and I’d recommend you read Jason Pressman’s post from Shasta Ventures for more context), but for today’s post, we wanted to cover an important but less-discussed aspect of employee options: do we denominate the option award in dollar terms or percentage terms?
Typically we see portfolio companies award options on percentage terms. This is by far the most common award methodology for start-ups because it is also by far the simplest: the start-up’s Board decides what % of the company it wants to award a new employee and multiplies that % by the number of outstanding shares.
A dollar-denominated award goes about things differently: it starts with a desired dollar amount to give to an employee, then divides by the value of the shares to figure out how many shares to award. This can yield a very different sized option grant than the percentage methodology. For more information on the nuances of calculating dollar-denominating awards, Fred Wilson of Union Square Ventures has an excellent post about the mechanics.
But which methodology is better? One of our portfolio companies recently wrestled with the two, and here was our perspective on the pros/cons of both methods:
I. Percentage Award:
Market Norm: Because percentage awards are more common for start-ups, there is fairly fulsome data available on what % amounts key c-suite hires typically receive. (And conversely, most new c-suite hires come in with a mental ballpark of what % amount they want to receive).
Ease to Calculate: Knowing the total shares outstanding, the board simply multiples the % it wants the new employee to receive by the total shares outstanding on a fully diluted basis.
Long-Term Understandability: It’s easy to pair a % of the company with a future exit value for an employee’s mental math. (“I own 5% today. If we hit a home run and exit in a few years at $100M, I’ll receive $5M down the road, minus a bit for dilution along the way.”)
Long-Term Planning: Boards carefully keep an eye on the “dry powder” (ie unallocated option pool) a start-up has to make sure that enough shares are set aside for employees – particularly key c-suite hires that will command large grants. A % method allows the board to accurately plan how many shares it will need for key hires up to a year or more ahead, because as long as the total number of shares the company has remain the same, the % allocation remains the same.
II. Dollar Award:
Market Norm Shifts: While not the market norm today, dollar denomination is certainly receiving more attention than it has in the past.
Divergence of Incentive: Because dollar denomination calculates the # Shares Awarded as [$ Award] / [Share Price], the lower a share price goes, the more shares an employee is awarded. This creates an opposite incentive to investors’ desire to drive up share value.
Difficulty to Calculate: One of the biggest hurdles on the dollar award methodology is figuring out the Share Price. Sounds simple, but for start-ups that lack good market pricing information and often have complicated preferred stock preference structures, it can be complex and very subjective to assess a share price value on common stock. The subjectivity in the pricing makes it difficult to frequently update a price for awards throughout the year, as well as potentially creating large swings in the sizes of those grants.
Short-Term Planning: It’s awfully hard to long-term plan share awards in the dollar methodology because you don’t know what the share price will be a year from now (or sometimes even 3-6 months from now). So dollar awards tend to work best for companies whose major share awards will be done in the short term, or who have very large option pools that don’t require minute-level advanced planning.
Near-Term Understandability: This is really the major factor in support of dollar-denominating share grants, and it’s worth pausing to point out its importance. An entry level worker typically doesn’t assign a mental value to the percentage that is as high as the value the Board and c-suite perceive; the worker sees a 0.005% award and often thinks “Hmm, that’s a nice gesture to be an owner,” but places little mental value on a bump up from 0.005% to 0.0075% from a performance award bonus. If the award is given in a dollar amount, though, it’s much easier to digest in ‘today’s value.’ (“Wow, I’m getting a $50,000 bonus valued today in shares --- that just so happens to bump me up from 0.005% to 0.0075%.”) Arguably the whole point of giving shares to employees is to motivate them through often sub-par cash salaries and long working hours, so if dollar-denominating shares helps them feel like they’ve gotten a tangible, understandable “bonus” and improves immediate productivity, then arguably that can outweigh the other difficulties of the methodology.
So which is best? Ah, but if the answer were simple, we wouldn’t need a blog post, would we? In reality, most of our portfolio companies continue to use % method awards for the reasons described above, but they try to specifically sit down with employees to help them see the value of the shares (sometimes easier said than done). One of our portfolio companies recently did choose to join a growing contingent of start-ups awarding based on dollar methodology, believing that the tangible, easily understood benefit for their employees was the most important factor. Both methods can work, but boards and management teams should take the time to carefully consider the pros and cons of methods, with the ultimate goal of retaining and incentivizing the best and brightest for their companies.