How Should You Manage Your Stock Option Plan?
“I was expecting an offer of three percent,” Joe said to me. I’d been recruiting Joe since before we got our funding, and, now, two years after we closed our funding, we had offered Joe 0.75% stock options to become a Senior Scientist.
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Joe had a PhD from Stanford, and the engineering team thought he’d be a great addition to the team. I did too, but three percent was just way too high.
“Joe, we just don’t have the equity (I use equity and stock options interchangeably in this article) to give you that (three percent),” I said. “That’s more than we would give a VP that we’d hire now. The offer we gave you was in line with other senior engineers we’ve hired.”
You have to stay disciplined with your stock option distribution or you’ll run out of them.
“The last time I joined a startup that’s (three percent) what I got,” Joe said.
“I’m sorry, but we just don’t have that much equity available,” I said.
“Okay,” Joe replied.
I could hear the disappointment in his voice. I knew he really wanted to join us, and, somehow, his expectations were out of line with the reality that I had to deal with.
You should have a plan for your stock option distribution by position.
Our Series A investors agreed to carve out 20% of our equity for the employees we hired. The stock option pool was expected to last at least two years.
We had a hiring plan by position for the next two years, so I knew the positions I would be hiring. And, I knew how much equity by position was the market rate for each position.
After that, it was just simple math to see if we had enough equity for all the people we were bringing on. If we gave Joe the three percent he was asking for, there wouldn’t equity for the other people we needed to hire.
Remember to carve out equity to refresh your team too.
If you want your employees to stick around, then you need to keep granting them more stock options, so they have a financial incentive to stay.
I’m a big believer in refreshing the stock options of your existing employees. Refreshing is the best way you can reward your early employees for the risk they took.
Ideally, this is how refreshing should work:
Let’s say you’ve just raised your Series B funding. Look at all of your existing employees as if you have to rehire them.
What would you give them in options as new hires at this stage? Add that to the back end of the options they already have.
So, an employee that was given two years ago 0.5% has vested half the options given. The dilution in the Series B was 20%, so 0.5% is now 0.4%.
A new employee with the same skill set (your clone) would get 0.3%. You should add two years of options worth 0.15% to the back end of the original options.
The employee’s options now look like this (after dilution):
Yr 0 Yr 1 Year 2 Year 3 Year 4 Year 5 Total
0.1% 0.1% 0.1% 0.1% 0.075% 0.075% 0.55%
Year 0 and Year 1 have vested, so the employee has 0.35% unvested options.
Maybe that doesn’t fully recognize your employees for the risk they took, but it’s the best you can do. Most importantly, refreshing your employees assures you will never have the case where an employee’s clone will have more equity than they will have. That’s just wrong and completely unfair.
You’re ready to present to your board how much equity you need for your employees once you have added your stock refresh grants to your new employee equity grants.
You’ll find you have a very unhappy board if you go back to ask for more equity before you should.
One of things about having a board of directors is it keeps you disciplined. Every employee stock option grant has to be approved by your board.
You’ll likely show your board a slide detailing how much equity is remaining in your stock option pool. And, you’ll show your board with each equity grant how much you want to give this particular employee and what the range for that position is.
Your board will quickly approve your future requests if you show you’re not giving away stock options like candy. That’s what happened with us when we finally ran out of employee options about 2.5 years after we started.