Who pays when startup employees keep their equity?

JD Maturen, 2016/07/05, San Francisco, CA

As has been much discussed, stock options as used today are not a practical or reliable way of compensating employees of fast growing startups. With an often high strike price, a large tax burden on execution due to AMT, and a 90 day execution window after leaving the company many share options are left unexecuted.

There have been a variety of proposed modifications to how equity is distributed to address these issues for individual employees. However, there hasn't been much discussion of how these modifications will change overall ownership dynamics of startups. In this post we'll dive into the situation as it stands today where there is very near 100% equity loss when employees leave companies pre-exit and then we'll look at what would happen if there were instead a 0% loss rate.

What we'll see is that employees gain nearly 3-fold, while both founders and investors – particularly early investors – get diluted. There is a small invariable loss, about 5%, to employees who are, incidentally or otherwise, at the company at the time of the exit.

Assumptions and simplifications:

• Constant annual equity creation rate for employees of 5% [1]
• Constant annual equity creation rate for investors of 10% [2]
• 10 years to liquidity [3]
• 3 year employee tenure
• 10 hires in the first year, 150% growth rate in hires/year
• Equity is granted in a given year proportional to headcount
• 100% loss of potential equity when employees leave the company before it IPOs
• Initially 1M shares in the company

At epoch (year 0) the founders own 1M shares, 100%, of the company. At the end of year one 50,000 shares (5%) are created for employees, 100,000 shares (10%) are created for investors. Etc. However as employees leave their shares get recycled or effectively nullified.

A spreadsheet laying out the math and it's consequences is available on Google Sheets. You can copy it to alter the conditions in Cells P2:Q6. Those cells also have notes documenting the meaning of each parameter.

The status quo

So what does this look like plotted out as percentage ownership in the company?

As you can see the 10% for investors really adds up but the ownership block for employees has an upper bound.

Plotting out just the percentage owned by employees we can see that it stablizes at 9.4%:

You can also see that only the employees hired in year 8, 9, 10 (the final 855) have any shares at the end of year 10. Quite bizarre!

A potential future

What happens if employees kept 100% of their grants? After 10 years employees would own 2.7x more of the company, 25.1% vs 9.4%. The average outcome for employees would thus be nearly 3x better. Employees still working at the company at the time of the exit would own 8.9% of the company, 5% less than the 9.4% in the status quo. A 5% hit to guarantee that you get to keep your equity. [4]

Who pays for this? Primarily founders who take a 25% hit after 10 years going from 33% ownership to 25% ownership, secondarily investors who take a 15% decrease from 58% to 50%. The cost to these parties is 5x and 3x respectively compared to the potential cost to employees at the company at the time of the exit.

Within the investor class the earlier investors lose more. Year one investors go from 3.2% to 2.3% about a 25% loss, pretty much the same as founders. Year ten investors go from 9.0% to 8.7% about a 3.5% hit.

Plotting out ownership by employee cohorts we see a much different picture:

The first 25 employees retain 3.9%, the next 58 employees 3.9%, the next 253 8.4%, and the final 855 8.9%. Much more sane!

Recommendations

Use single-trigger RSUs right from the beginning. Full stop. The only valid circumstance for stock options for employees is 83b'd early exercised options when the strike price is a rounding error, i.e. no money has been raised.

If your company already has a significant investment in stock option grants then think creatively about ways that you can extend the execution window – ideally indefinitely – or convert options to single-trigger RSUs. If you already have the low option execution rate baked into your long term planning then you will need to figure out how to communicate that to your employees.

Footnotes

1. Andy Rachleff states that “As a point of reference most public technology companies increase their option pools by 4% to 5% per year.”
2. Assumption of a 15% round every 18 months = 10%/year.
3. It is quite likely that stock options as a mechanism worked much better when the average time to IPO was shorter. According to a16z the median time to IPO has increased from 4 years to 10 years.
4. Importantly, this is invariant to the annual employee equity creation rate. You can play around with values in cells Q3 and Q4 to see this.