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Curated by Founders Circle Partner

Why the Stock Options
System is Broken

The following perspective comes from interviews of Founders, CEOs, CFOs and GCs of several of the 24 companies Founders Circle has had the privilege of working with (far too many names to include in the byline). As each of these leaders reflected on the aligned liquidity programs they organized for their companies, they wanted to offer a POV of “knowing what I know now, here’s what I’d do differently”. The Partners of Founders Circle sincerely thanks everyone for their commentary.

Incentive stock options plans were originally designed to encourage employees to patiently help build startups over the long-term. By leaving the company, they’d forfeit a shot at a large amount of money.

But with the most successful startups staying private well beyond the old IPO windows—the median age of a company when it makes its IPO has grown from 7 years to 12 years—the entrenched stock option structure hurts both companies and employees, forcing workers to stay at a job longer than they want and companies to hang on to executives they’re ready to replace.

This doesn’t need to be the case, though. We’ve helped 22 companies navigate these waters, and had countless conversations with executive teams who are trying to solve these problems. The good news is that it’s easy to design an incentive program that meets the needs of both a company and its workers. The thing that’s become more clear to us over the years is that it just requires a little planning in the years leading up to hypergrowth.

Staying private longer makes a lot of sense for #breakawaygrowth companies. It allows them to focus on their operations and not worry about quarterly reports. It also means that more of the wealth creation that occurs as the company grows goes to employees and early backers, as opposed to public investors.

The downside, which many companies only realize too late, is that the stock option structure as currently designed doesn’t scale well beyond year seven. And it can create a variety of problems if companies don’t take steps to do something about it early.

To understand why, let’s first cover some basics. There are two separate costs for employees to exercise their vested options. The first is the purchase price. This is typically a fairly low cents-per-share figure.

The second is related to the tax liability. That’s the crusher. Purchased options are taxed as ordinary income; if the vested options are exercised during years 7 through 12, when the company’s valuation is skyrocketing, the tax is assessed on the difference between the strike price and the 409A price. This is typically several dollars-per-share. Many people simply can’t afford to pay it because, in all likelihood, their startup salary didn’t allow for socking away the kind of cash necessary for such a large transaction.

Trapped

So, what happens in today’s highest performing startups? What we’ve seen is that employees, all the way up the ladder, men and women who have worked incredibly hard to help build the company are feeling trapped. Here are a few scenarios where employees face either losing their hard earned vested shares or face a huge burden by having to come up with the cash for the exercise price and tax liability:

  • If the employee is a good financial planner, she might want to exercise her vested options in an effort to get those shares into long-term capital gains, which have a much lower tax rate. However, without the necessary cash, she’s forced to hold and wait to exercise and sell at the same time, at the future exit date, where her tax bill will be at the higher ordinary income rate. A significant portion of wealth that should have gone into the employee’s pocket goes to Uncle Sam instead.

  • If an employee has no intention of leaving the company and is planning on patiently waiting for that future exercise and sale event, he’s going to come up against an ominous immovable wall with a federally mandated expiration of all options after 10 years. Today, employees across all kinds of private companies are starting to be forced into a very stressful and potentially demoralizing “exercise it or lose it” situation.

  • If an employee wishes to or needs to leave the company, he usually has 90 days, mandated by the company, to come-up with the necessary cash to exercise his options or face having them expire and absorbed back into the company. So people stay. But they’re not happy about it.

  • Then there are companies who can’t bring themselves to let an employee go when they’re no longer a fit. We’ve seen people remain employed for years because the company cared about them, valued their contribution in the early days of the company and didn’t want to put them in an exercise it or lose it situation. These people are often referred to as “vest in peace” as they’re shunted off to some far flung part of the company in a low impact role. The goal of a company should be to have motivated, energized employees who want to be there to build a company—not forced to be there because of financial constraints.

From our point of view, the options structure has become antiquated and unfair to those team members who have been steadfast contributors to the company’s success. How can someone come up with $1 million or more whether she wants to stay or it’s time for her to leave? Don’t employees deserve to have maximum optionality to create wealth for themselves and their families?
 

Solving the liquidity problem

Over the last several years, Founders Circle has helped some of the fastest-growing startups navigate these landmines by implementing company-sponsored liquidity programs that allow employees to sell some vested options. To balance the retention vs. reward goals, we usually cap the amount and percent of vested options each employee can sell.

These program provide a big pressure valve relief, as employees have a chance to address their own set of life needs—homes for their families, debt hanging over their heads, college tuition, a sick parent, and so on.  

Without programs like these, employees sometimes find their own way in a treacherous secondary market, where they risk selling their shares at a deep discount, perhaps 50% of what they should have gotten. Often, employees don't have the experience of sophisticated buyers; they lack complete financial information and sometimes have difficulty expressing the strategy and vision of the company in a way that justifies the real value.

Sometimes, these transactions run afoul of company policy from selling outside of a structured program. Furthermore, companies risk seeing those shares fall into the hands of new shareholders whom they don’t know anything about.

We believe that employees should have maximum optionality. Companies, especially #breakawaygrowth companies, need the flexibility to deal with the issues that come out of growth. We strongly encourage founders and boards to have a plan in place for managing liquidity by year seven, the time when a few years ago they might have gone public.
A managed secondary program restores wealth creation to employees, giving them the flexibility to leave jobs they’re ready to leave—or that the company is ready for them to leave.

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