Options about your Options – How to think through your company’s option program

Quick break from Covid related topics for a moment to post something I’ve been intending to write about for a few months but haven’t had the chance to commit to paper. It’s perhaps a boring topic – Options and your company’s option program – but an important one.

Despite how much time companies talk about the importance of their employees and, in many cases, how every employee is also an “owner” of their business through their option program, most companies are pretty ad hoc (or down right sloppy) about how they plan for and execute their option program. My hope with this post is to push your thinking around options and encourage you to formalize what you’re doing into an actual option program.

Side note before we jump in. I’m not giving any tax or legal advice here. You have accountants and lawyers for that – be sure to check with them. I’m also not going to give option bands for various positions. The data change over time and, frankly, I’m less interested in debating what % grant your Director of Product Management should receive given your stage of company and capital raised, and more interested in the structure of your program.

Why have an option program to begin with? It strikes me that many founders never really consider this question. That’s a mistake because knowing what’s driving your desire to give out options will inform how you think about your option program. Many founders feel that it’s equitable to have everyone share in the upside and feel like owners. Some feel that, especially for early employees, options should act as a reward for taking startup risk. Many startups use option packages to compete with the larger current comp packages of bigger, more established businesses. Yet others try to use cash to minimize dilution for early employees and try to rapidly reduce their reliance on options. All good, but different philosophies (and different markets and market conditions) can lead to different initial option programs. One thing not always acknowledged is that often option programs are intended to be mercenary in nature – binding employees to the company through the disincentive of needing to exercise their options (and in some cases pay tax on the paper gain) if they leave. What your value system looks like and why you’re setting up an option program can and should have ramifications on how you set up your option program. No value judgments here – my goal for you is to be deliberate about why you’re giving employees options and to align the details of your program with what you’re trying to get out of it.

Should everyone in my company have options? The answer to this should follow from the answer to why you’re setting up an option program in the first place (and can potentially change over time as you grow your business). Many, but not all, Foundry companies give options to all their employees. Often this is due initially because founders feel that it’s “right” for all employees to have some ownership (or right to ownership) in the business. Others feel less strongly about it and either don’t distribute options below a certain level of employee (say manager level) or have programs where employees need to be at a business for a period of time before they earn the right to have an option grant. Obviously, there are competitive considerations to think about, but in some markets, options are either not well understood, aren’t expected as part of an employment package, or aren’t commonly given to employees below a certain level. Take a moment to decide whether you feel that everyone in your company should have the potential to be an owner and what’s driving your thinking about why.

Using options in lieu of compensation. It is very common for companies – especially companies early in their lifecycles – to try to use options to reduce the total cash outlay over time. That’s ok, but there are a few things to keep in mind if you’re doing to do this. The first is to be deliberate about it if you’re going to do it. By that I mean pick a “value” for each option and formulaically apply that to decrease comp. This option value can change over time (your company grows, raises more money, and reduces overall risk, etc.) but if you’re going to use options this way be methodical about it. We’re going to talk about setting deliberate option bands for various levels in your company in a second and the starting point for options should be those bands. From those your offer to an employee can methodically (meaning formulaically) reduce cash and add options. I’ve sometimes seen companies make offers with a range of salary and options – making explicit the trade-off they are offering between cash compensation and options. It’s important to recognize that not all employees will value options in the same way (or be in a position to trade cash comp for options). It’s also important not to go crazy with the trade-off. For starters, it can lead to inconsistencies in comp that are too large to sustain over time. But it will also change the nature of your workforce if you only hire employees that can work for well below market cash comp. Both of those things are not good for your business, so while it’s ok to offer some level of cash/equity trade-off, it shouldn’t be over-done. It’s also my experience that as companies grow they seek to normalize both cash and equity compensation over time, leading to some inconsistencies in how early employees are treated (cash comp tends to come up more quickly than equity comp so if you’re not careful you’ll further disadvantage early employees who took larger initial cash compensation – this is both not fair and can be discriminatory). So use this tool judiciously and over time as you have greater cash resources, it should be reduced or eliminated.

Create option “bands”. Every company should create a schedule of new hire grants for each level position in their business. This schedule should lay out the range of options that you’re targeting for each position in your business. This exercise should be done annually and reviewed with the board (and/or compensation committee of the board if you have one of those). This will help do a few important things including setting appropriate expectations with your board about equity comp, ensure that you’re not making ad hoc compensation decisions, avoid various forms of bias in the hiring process around granting equity and allow you to quickly and seamlessly get option approval from your board. This will also force good conversations about outliers and, in my experience, tends to be a deterrent to title inflation, which I hate. In summary, don’t be ad hoc about options – be methodical about them.

Option Exercise. Typical option plans allow employees only 90 days to exercise their options once they leave a company. This can be a real incentive for employees to stay at a business, as there are often meaningful tax consequences to exercising options upon leaving (again, I’m not giving tax advice; this is actually something I’d like to see changed in the tax code. More complicated than I want to dive into here, but it would actually benefit employees and also the federal coffers as the tax would get paid on greater gains when the stock is eventually sold. And it would be the more fair thing to do, but I digress). Interestingly, there was a move a few years ago to extend the option exercise period after an employee left to a much longer window – say 7 to 10 years. Pinterest, Kickstarter and a handful of other relatively high profile companies did this. I suppose the idea was that it was an employment perk – like a better healthcare package or free lunch. At the time I had mixed feelings about it and I still do. Options have value because of their optionality – at some point in the future they may become worth a lot of money, but so long as you stay employed by your company, you don’t have to invest (purchase your options) and essentially get a free ride on the potential upside. Something about continuing that free optionality (essentially at the expense of other employees who stay at the firm) feels off to me. But, I know others disagree, and ultimately the choice here relates to your goals for your option program, your personal views about equity ownership and participation and your thoughts on fairness (which could swing this either way). But better to have a view on this that is deliberate. If you don’t say anything about it to your lawyers, your option plan will almost certainly have a 90 day exercise window.

Option Refresh. Even companies that are methodical about their option program set-up often skip this key element of a successful option program. I think it’s a super interesting (and important) part of that program and have put quite a bit of thought into how to best structure time based refreshes to employees. My background thesis inherent in this is that employees with options should continue to vest new option as they continue to work for your business. I think this is both practical and fair.

Here is an idea for what an option refresh package should look like:

• At an employee’s 3rd anniversary, give them a new grant equal to the greater of a) 25-33% of their existing option grant; or b) 25-33% of what a new employee hired for that position today would receive.
• The grant would begin vesting on the employee’s 4th anniversary and will vest monthly over 4 years.

This formula works pretty much across the board, with the exception of founders, who need to be considered differently (founders with meaningful ownership typically are not included in refresh grants). To be clear, what I’m describing here is separate from promotion grants and from annual or semi-annual performance related grants (which I think of as more a part of a company’s compensation policy than their Option policy).

Hopefully this post will give you some ideas for how to best structure your own option program. I’ll be interested to see your feedback either below in the comments or directly to me.