Your employee options plan

Many business owners are short-sightedly selfish with their shares.

Initially, the founder often wants to own as close to 100% of the shares of ‘his’ or ‘her’ company as possible, to stay ‘in control’. Shares are sold only if absolutely necessary to raise money (foolishly, at the highest possible valuation). Options are sometimes forced on the founder, only as a way to attract top management.

Public businesses also reserve options only for top management, with massive option grants for the CEO, smaller grants for top managers (and the board, who approve the options package), and none for everyone else. The idea is presumably that only the CEO and top managers can affect the company’s success.

We know that’s not true. Every employee’s work is crucial. The small size of early stage companies just makes this more obvious.

Options therefore can, and should, be a tool to reward everyone. Here are things to think about in designing, or evaluating, your option plan.

The legal side of options matters

Options do not give you ownership in the company. Instead they are a contract, that gives you the ability to buy ownership, at a set price for a certain future period.

If you are a shareholder, you are protected from some abuses by law. If you have a contract to buy shares, you are protected only by the contract.

It’s therefore important to do it right. Otherwise, when the company is worth a lot (and possibly run by new owners), the early option holders may end up having their contract invalidated.

I’m not a lawyer, and I suggest you talk to one and/or make sure you use a precedent which is up-to-date and appropriate for your jurisdiction. You can also ask your lawyer or accountant whether you should issue actual options or ‘restricted stock units’.

Standard option contract terms

Three terms matter in designing or evaluating an option plan.

  • the vesting period: you normally issue/are given options today that vest over a number of years (a good number is 4-5 years). Options are issued based on today’s price, and will have value if the company is worth more. One important feature to watch for is whether the options all vest immediately in the event of an acquisition (they typically should).
  • what happens when the employee leaves: some people feel that when an employee quits or is fired, they should be forced to either exercise (buy the shares) or lose their options – since they can’t contribute to future success. Others feel that vested options stay with the employee – since they ‘earned’ them from their contributions. I would recommend looking at the employee’s salary: if they were paid market rates, then losing the options makes sense; if they were drastically underpaid then they should keep vested options since that was an implicit part of the compensation.
  • how long the option is good for: a standard period is 5-7 years. When you consider that for early stage companies, it often takes 7 years to reach an exit, it is important to issue the options for as long as possible (typically 7 years). I have often run up against the edge of vesting periods in previous companies with my own options, which causes a very uncomfortable decision: either spend money you don’t have to buy the shares, or lose the options.

How much to give

You should think of your options just like you do cash: there is a limited amount, and you need to figure out how best to share it around.

Your total options budget will be 10-20% of the shares outstanding. This needs to cover all management and all employees, both today and in the future.

Did I say ‘all’ employees? Yes.

I often find that junior employees especially don’t value options, and would rather have cash. Think about it this way: what if they do a fantastic job, and your company sells for hundreds of millions of dollars. Do you want them, the people who created that success, to get nothing?

It’s very hard to give them a piece of that success when it actually happens: even the best meaning owner often finds it hard to write $100,000 bonus cheques from their millions to each employee … especially if you are the only one of the shareholders compensating them. It’s easy to give them options today: which dilute all shareholders equally.

As a general rule, you should set aside 2% or so of the shares for ‘all employees’.

Thinking about the future

When issuing and budgeting options, I have historically tended to focus on the initial options grant, with the hidden assumption that the initial grant will provide ongoing motivation to people.

I have seen how this isn’t always true.

The founder of a company I ran previously got very upset over not being in the company options plan. My attitude was that he had ~30% of the shares, why should he want any more? His attitude was that was ‘in the past’; he was an employee too, and what had the company ‘done for him lately’?

This interesting article offers a new way of thinking. They suggest average grants of around 0.1% of shares per employee, and split an employee option plan into four pieces:

  • initial grants when hired
  • additional grants on promotion
  • bonus grants yearly for outstanding performance (only)
  • additional grants as previous grants vest

I’m going to be rethinking my own approach to options as a result.

Maybe it’s time to think about or review your own options plan?