When Should You Stop Giving Equity To Your Team?
I was in a board of directors meeting for a company I am advising. The discussion moved to stock options. One of the investors, “Michael” said, “We should set the strike price as high as possible so employees that quit will not exercise their options.”
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Most of the other people were nodding their heads in agreement. Then I said, “That’s wrong.”
It became very quiet. I continued speaking. “We want to set the option price as low as possible so employees will exercise their stock. This will help us in the long run.”
The expression on Michael’s face was priceless. He didn’t agree with me and he was starting to turn red with anger.
I kept going. “We want a reputation for being generous to our employees. It will come back to bite us if we’re not generous.”
The rest of the board was not swayed by my argument, so the high option price was enacted. It’s still too early to tell if this will hurt the company or not, but I don’t like the trend.
You want to retain your employees for as long as possible. That’s why you want to continue giving your employees equity.
After the board meeting, I started thinking about the fight we were going to have in a couple of years about refreshing the stock options of employees. I didn’t think it was going to go well if Michael continued dominating the board.
Michael’s view about employees sadly isn’t a unique view. Many investors and CEOs have this “It’s all about me” view of a company.
I pitched “Ray”, the CEO, on thinking about refreshing employee stock options at least after every financing if not every year to two years. Here’s how refreshing employee stock options works:
Let’s say you hire an employee and you give the employee 0.5% stock options that vest over four years. Two years later, you go through a round of financing that is 50% dilutive.
The employee now owns 0.25% and has vested 50% of the options. A new employee you hire for the same role, based on the market rate, would get 0.3% post funding.
The question is should you refresh the older employee? I say the answer is yes.
The older employee should get two years of options worth 0.15% because that is what the role now pays (0.075% per year). This rewards the older employee for the risk the older employee took by joining the company earlier, and it keeps the employee with golden handcuffs going forward.
Refreshing should protect your longest tenured employees.
Why should someone that’s been with you longer get less than someone that joined later? The answer is this should never happen.
And, with the proper use of refreshing, it never has to happen. By adding options, so employees always have four years of options ahead of them, you can keep everyone financially motivated going forward.
Let me give you a real world example of what happens when your equity vests that can be translated to startups.
I worked at two companies in the same industry that had very different views on how to handle employee stock options.
The first company, Maxim Integrated Products, had a policy of refreshing their employees stock options. Every year, Maxim would add another year of options onto your existing set of options, so you always had four or five years of unvested options in front of you.
And the new grants weren’t a token amount of stock options. These grants were like the company was hiring you again, so they were worth a lot of money.
The result of having a large chunk of unvested options was that employee retention was high at Maxim. People rarely left.
The second company, Micrel, also had a policy of refreshing their employee stock options. However, the new grants were not generous at all. They were about 10% of the value of the initial option grants.
The result was the average time a typical employee spent at Micrel was around 4 years; the exact same time as their initial stock options took to vest.
It’s not a coincidence that employee retention is directly related to the expiration of stock options.
CEOs and investors forget that talented people have choices. Why should someone stay if there is no ongoing incentive?
That’s why Maxim’s employee retention was off the charts, and Micrel’s was the length of the initial grant. Interestingly enough, when Maxim had to veer away from its stock option program because of Sarbanes-Oxley, employee retention went down.
Epilogue:
Michael's sway over the board diminished over time. Ray was able to convince his board to refresh the stock options of his existing employees at a generous amount.
Employee retention stayed high, and Ray's company is now worth over $2 billion. I don't think this is a coincidence.
For more, read: What Are The 5 Rules You Need To Divide Founder Equity?