Closing the Information Gap on Employee Option Grants: Part Three

This post explores the dimension of time in the grant of stock options. Time delineates the grant of options: the time it takes to obtain full ownership of the options and the impact of time on dilution or vesting. Acceleration - the ability to make time go faster in option grants - is also discussed in this post.

In my previous posts (see here and here) I argued that employers should give employees more information about their stock options, enabling employees to make an informed decision when negotiating option grants, and closing the information gap. To that end, I’ve suggested a stock option template addendum for employment offers.

In this post, I will go into more detail regarding the time aspect of option grants, looking at dilution, vesting, exercise post-termination and acceleration.

As time passes: dilution

What is dilution? dilution happens when there is an increase in the amount of outstanding shares (as a result of new investment rounds, allocation of new stock option pools and more), resulting in a smaller percentage holding of the company for a specific stock (or option) owner, thereby “diluting” holdings.

How much dilution should be expected? Within a given investment round, venture capital funds typically look for 10% (hot, highly competitive deal) – 20% (typical) – 35% (aggressive investors, stay away) holdings. They also require that the company pre-allocate ESOP for future employees, so that the ESOP allocation won’t be dilutive to their fund’s holdings, but rather occur before the investment round. In a typical scenario of new funds invested in the company, each early round dilutes the holdings in the company by 10% (at the extreme low end) to 40% (at the extreme high end). This means that your percentage holdings will be diluted at the same rate. You should assume that a company will go through about 3 major funding rounds throughout its life (you might be coming in after one or more of these rounds happened). At the end of the road, a typical capitalization table will be 60% investors, 15% ESOP and 25% founders.

How much time: vesting

Vesting is the time an employee has to wait in order to be able to exercise stock options. A 4-year vesting period means that the employee will have rights to all the options granted to her only when the 4-year period has elapsed. The “vesting schedule” is what determines the size and timing of the  “chunks” in which vesting will happen. 

Typically, vesting schedules begin with a “cliff”.  The “cliff” means that there is no vesting before a certain period passes (for instance, no vesting before one year passes, something that reflects not knowing whether the employee fits into the company culture). In the past, the “usual” vesting used to be 4 years with a one-year cliff – the first chunk of options is released after one year, and then options are released (pro-rated to the time that has passed) in smaller chunks, such as a monthly or quarterly basis.  

ADVICE TO EMPLOYEE: One less negotiated term is the vesting schedule after the cliff. A fairly typical term is that vesting will continue on a quarterly schedule (i.e. one quarter of the shares allocated for that specific year will vest at the end of the calendar quarter). You can definitely ask for monthly vesting after the cliff. In case you leave or are terminated 2 months into a quarter, you can still get 2 additional months worth of options. In addition, see note in my earlier blog post about negotiating a higher number of options in return for a longer vesting schedule.

ADVICE TO EMPLOYER: Vesting periods in Israel have started inching towards 5 years, because that’s typically the expectation of how many years of work the employee is supposed to contribute to the company.

When time is up: post-termination option exercise

Options don’t stay alive forever. When employment is terminated, the employee has a limited time to decide whether or not she would like to exercise her options; if a decision isn’t made, the options become void. The exercise duration – the time the employee has to make up her mind – is typically limited to 3 months but can be extended by the company’s board of directors.

The company’s perspective is that it doesn’t want the question of whether an employee will exercise her stock options to remain open for too long, since this creates a lack of clarity as to the capitalization table – the dilutive effect of the option exercise on other holdings in the company can’t remain unresolved for too long. On the other hand, especially if considerable funds are required for the exercise of stock, the decision of whether to exercise can be a (very) expensive one, and done  under (severe) time pressure, requiring the employee to predict the long-term success of the company, right at the time of leaving it.  

ADVICE TO EMPLOYEE: You should always take care to leave in good terms, and ask for a longer  exercise duration as your key “ask”, in return for an orderly knowledge transfer and making yourself available to the company for future questions. Keep in mind that the company needs clarity as to its capitalization table too.

ADVICE TO EMPLOYER: In general, it’s a good practice to allow employees that worked hard and supported the company to enjoy a future upside. This is an easy “give” as there is no inherent cost. Note that repeat behavior determines “standard company practice” which in return can trigger lawsuits if you don’t provide the same terms to other employees.

Making time run faster: acceleration

Another term that is negotiated with regards to option grants is acceleration. What is acceleration? If an event, or series of events occur, the employee gets the right to exercise all her options, even though the time in the vesting schedule hasn’t passed. Generally, when an exit occurs, the default is that vesting will continue as before, with the acquirer assuming the remainder of the vesting schedule. The theory is that the employee signed up for a vesting period in return for the options, so the vesting  should continue as per the employment agreement, releasing comparable options or RSUs in the acquiring company in return for continued employment. Acceleration means that the employee has all options vested right when the exit occurs.

ADVICE FOR EMPLOYEES: However, there are some justifications for acceleration. The case for acceleration has to do with whether the employee will get a chance to continue vesting post-acquisition. What happens if the employee is demoted? or her services are no longer needed post the M&A event? if the site is closed after the acquisition? For engineers, dev-ops, designers or product managers that is less likely and acceleration is rarely if ever granted, but high-ranking marketing and sales are at risk. Unconditioned (“single trigger”) acceleration is almost never granted (just getting acquired, for instance), but sometimes you can negotiate what’s called “double trigger acceleration” – if you get acquired AND get fired within X (usually 12) months of the acquisition, your vesting schedule will be accelerated.

ADVICE FOR EMPLOYERS: The case against acceleration is the way acquisitions work: for the acquirer, the total acquisition price is a combination of cap table payment and the costs of employee retention. If acceleration is given to employees that the buyer wants to continue employing post acquisition, the  buyer will need to allocate additional capital for retention, since the acceleration has terminated their vesting schedule. As a result, acceleration could result in re-allocating funds from cap table payout to retention and actually lower the total acquisition price. This can have the impact of reducing the payout to the investors and (to a lesser extent) the founders. In extreme cases, such as top talent having acceleration and/or maybe acceleration as a general rule for all employees, investors could push back on agreed company valuation post legal due diligence.

This ends our series about stock option grants. You can read the first and second posts here. I hope that showing how stock option grants work within the Israeli tax regime and delineating what requests and terms make sense, taking both the company and employee point of view, lets people better understand and place a value on option grants. Option grants are an important tool for startups and if they are misunderstood, all sides stand to lose. 

When you get offers, suggest to the company to use my stock option template addendum for employment offers. Both sides will benefit. Also, don’t forget to update your grants in the spreadsheet and grow the knowledge of the eco-system, and ping Avigail Levine if you’d like to see what great employment opportunities exist in the Aleph portfolio.