Monday, April 23, 2012

Option recycling: logical assignment of equity at early-stage startups

I've been giving a lot of thought to equity distribution to early employees at startups.  In this post I will describe a method for recycling employee stock options which offers early employees much higher stake in the early development of the company.  Importantly, it provides an incentive for employees who are currently priced out of the startup labor market to enter it.

This post piggybacks off of a post I'd made earlier about why people start startups.  Aside from the personal satisfaction one can achieve from this scenario, there are clear financial motivations to found a startup instead of joining one.  To summarize: the founders get a large equity stake, and successive employees take on much, much smaller equity stakes -- often one or two percent, even when the company is still very much trying to figure out its business model.

The traditional model is bad because it prices certain employees out of the startup market.  In this post I'll summarize a typical scenario and then describe an alternative method which involves recycling options and which could make startups more attractive to strong, experienced employees.  In the very last section I outline a very simple way for employees to decide when to take on a new coworker and how much they should offer to the coworker.

A typical scenario

In a very common scenario, a startup founder (or founders) will retain at least 50% of the company and offer small equity grants, say 1% to 3% -- plus a modest salary -- to early employees.  These grants become meaningful if the company becomes worth $20M or more: a 2% grant may then be worth $100K per year if it vests over four years.  With a salary of $60K, this is like getting $160K per year.  Sounds good, right?  Potentially, until you start looking at salaries at some of the top tech companies, which are regularly offering packages around $200K per year to candidates with experience.  Even if the company sells for $100M (not bad for four years!), the equity grant is $560K/year.  This sounds promising until you consider that $100M is the exception rather than the rule.  If even 1/4 of these companies make it that high (and that's being optimistic), and the rest fail, the expected value is back down to $185K/year.  And that's with high variance: the usual risk/volatility trade-off -- in which investors take on volatility to achieve higher gains -- is reversed.

This means that experienced, older engineers willing to work hard have very little financial incentive to join an existing, early-stage startup: it is more rational to either found a startup (where they might have a 17% or 26% stake) or work at a top tech firm.  This is one of the factors contributing to the explosion of startups and the lack of engineering talent (easy credit and lower barriers to entry are two other factors).

This fixed equity + fixed salary mechanism is both antiquated and arbitrary.  Standard equity grants (with modest salary) may also mean that the payoff gap between founders and early employees can be significant enough to incentivize the founder to sell the company cheaply; promising young talent is then left with modest (often below-market) income, while the founder has earned millions of dollars per year.

As I pointed out, this is largely an artifact of the equity-salary trade-off.  What if instead we designed a payment structure in which employees' income grew at a rate proportional to the growth of the company, but inversely proportional to the number of employees? (Note that high-level roles in the company would of course have multipliers attached to their positions.)  We can easily accomplish this by recycling options: early employees receive larger grant amounts than is currently typical, but they are then required to underwrite option grants to later employees at pre-specified increments.

To simplify the discussion, let's pretend that employees arrive in increments, and that we know the valuation of the company when they come in: the first four come in at valuation $0, then four more come in at $20M, then sixteen more at $100M, and so on.  It's easy to extend this to a continuous-time case, but these assumptions make the discussion easier.

Option recycling

An option-recycling scenario would look like this:
  1. Employees one through four each get call options representing 8% stakes in the company with a strike price at the most-recent valuation.  This high stake is mitigated by each employee's contractually obligated short position on call options representing a 4% stake with strike price based on a $20M valuation, and further short positions on call options representing a 2% stake at the even higher valuation $100M, et cetera.
  2. Employees five through eight each receive call options representing 4% stakes at $20M valuations, and they're required to hold short positions on call options representing a 2% stake at $100M, 1% at $500M, etc.
  3. This means several things:
    1. Early employees will lock in higher earnings sooner, with lower risk of the investors selling the company for talent.  An early employee with an 8% stake in a fledgling startup has enough of a stake to reasonably appreciate a $20M acquisition: it's $1.6M total, or $400K amortized over four years -- higher than the vast majority of strong individual contributors will receive at a large top tech company.  This contrasts with a 2% stake at a $20M valuation, which is $100K/year -- lower than an individual contributor will receive at top tech firms.  Is this hedging of risk a bad thing for individual contributors?  Not if you consider that the founder has a significantly larger cushion.
    2. Early employees will receive lower payouts for later company growth. An early employee's income per dollar valuation decreases as the company grows larger.  If the company is worth $40M, one of the first employees will find that his income from options is (8% * $40M - 4% ($40M - $20M) ) = $600K per year (over four years).  This increase of "only" $200K makes sense because there are more employees at this later stage of growth.  It's not fair for early employees to take credit for later employees' contributions, unless it's been priced in based on a special role these early employees now play (manager, director, CTO, president, etc.).  These special roles should of course be priced in by refresher grants and salary, but fixed equity stakes at the beginning make no sense.
    3. The first four employees (after the founders)-- who together might reasonably explain 32% of the first $20M of growth -- each get an appropriate share of that growth as well as an adjusted share of future growth.

Here is what the early-employee compensation world currently looks like:
In the plot above I show the value of a company as a function of time.  The employee equity pool (the medium-curvy line) is a fixed fraction over time of the company value (the higher curvy line).  The first employee's equity as a share of the company is the lowest curvy line.

The total of employees' equity at the end is represented by the vertical bars stacked on the right side, the total length of which corresponds exactly to the options' above-water value.  Note that this sum is not the same as the value of the assets underlying the employee stock option pool because later employees received options with a higher strike price:  Say one of two employees gets 1 option at strike price $0 and the other gets 1 option at strike price $20; then if the company is valued at $50 per share, the amount the two employees receive from options is $30 + $50 = $80, not $100.  We could call the gap between the value of the assets underlying the options minus the above-water value of the options (i.e. the height of the employee medium-curvy line minus the sum of the lengths of the bars) the dark wages because it was never assigned to employees in the first place; it was essentially value contributed by early employees that was never paid back to them.

Founders and investors are loath to grant larger amounts to early employees because they typically assume that once an option is granted it can't be re-granted.  Recall that we solved that problem by having earlier employees recycle their option grants to later employees.  The early-employee compensation world now looks more like this:

The shaded region represents an individual's contribution during that period.  We're simplifying, since his contribution will often increase as he gains more seniority, but the basic idea is sound: his compensation from the company in any period should aim to be proportional to 1/(number of employees).  The company will grow some amount, and an individual's share of the company will grow at an amount which is also proportional to his stake in the company -- and, if hiring is consistent -- proportional to his contributions to the company. Notice in particular that an early employee will have a much larger stake in the early performance of the company.  This is compensation for the risk the employee is taking.  In the original scenario, the employee was taking outsize risk for the first $20M in growth of the company.  In the modified scenario, the employee's equity value is fairly high by the time it's ready to take on the 9th through 16th employees

You may wonder why the blue bars are stacked precariously.  If you look carefully, you'll see that the top of each blue bar at the end of an epoch is aligned with the top of the blue bar in the next epoch.  I illustrate it this way to show how an employee's cumulative contribution toward a company usually continues to grow, but at a rate which decrease with the number of employees.  His increase in value-added (and compensation) during the entire period is the sum of his increments in each period -- the height of the small vertical bar on the right.  Importantly, note that there are also no dark wages. This is because early employees held stock as it increased in value before passing it on to later employees.

Valuing an offer with recycled options

We haven't yet discussed how to estimate the strike prices and amounts of employees' short-call positions.  Valuation of these is an open question, but it is not conceptually any harder than valuation of employee stock options.  The only additional variables it requires estimating are the size of the company (in terms of employees) at future valuations.  Plenty of training data exists for this, and humans will be able to make educated adjustments to model typical outcomes.

A further thing to note is that offering employees equity which has higher value at earlier stages in the company does not require that the employees be  able to cash out early.  Instead, they are simply underwriting options for later employees.

Giving employees the option of when to hire (and when to split their equity)

A final model I'll propose is that employees be given the option of splitting their options to take on another employee.

At any time, the current employees (say there are N of them) will be given the option of bringing on more talent by offering a stake of their equity.  There will be a point at which this should be not only rational but attractive: as the company progresses with a fixed number of employees, they will reach a local optimum of the company's valuation, at which point their options cannot increase in value.  At this time, it is completely rational for an employee to realize that his X% stake cannot grow any further without bringing on another employee.  If each employee gives X% * / (N+1) of his stake as call options to an incoming employee (who then has the same amount as each old employee, but with a higher strike price), then the original employee's remaining N/(N+1) * X% can continue to grow.  Again, each employee gets credit for growth he has contributed to, but no more.

This is similar to the above analogy, but it gives an employee control over his equity stake.  As the company continues to grow, employees (and founders and investors) can make such decisions completely rationally.