The True Worth Of – Employee Stock Options (ESOPs)

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Forty years ago, the biggest component of executive compensation was cash, in the form of salaries and bonuses. Stock options were just a footnote. Now the reverse is true. With astounding speed, stock option grants have come to dominate the pay—and often the wealth—of top executives throughout the world are now granted in stocks.

When a group of engineers launched Fairchild Semiconductors—the first chip start-up in Silicon Valley—in 1957, investors offered the founders a relatively new type of compensation: stock options.

By the mid-1970’s, investors in venture-funded startups began to give stock options to all their employees. On its surface this was a pretty radical idea. The investors were giving away part of their ownership of the company–not just to the founders, but to all employees.

What they mean –

Employee stock options –

Mechanically, a stock option was a simple idea – an employee received an option (an offer) to buy a part of the company via common stock options (called ISOs or NSOs) at a low price (the “strike price”). If the company was successful, the employee could sell the stock at a much higher price when the company listed its shares on a stock exchange (an “initial public offering”) or was acquired.

Executive Stock options

Executive stock options are “call” options. They give the holder the right, but not the obligation, to purchase a company’s shares at a specified price— The ‘exercise’ or ‘strike’ price.

The options issued to executives usually have important restrictions. They can’t be sold to a third party, and they must be exercised before a defined maturity date. Executive stock option are generally given to the executive of larger companies as compensation and incentive.

Talking about Employee Stock Options –

Why they are vested –

ESOPs were vested because startups didn’t have much cash and couldn’t compete with large companies in salary offers, stock options dangled in front of a potential employee were like offering a lottery ticket in exchange for a lower salary.

Startup employees calculated that –

o  Their hard work could change the odds

o  Someday the stock options they were vesting might make them into millionaires.

Investors bet that by offering prospective hires a stake in the company’s future growth,

with a visible time horizon of payoff

o  Employees would act more like owners and work harder, and that would align employee interests with the investor interests.

o  It drove the relentless “do whatever it takes” culture of 20th Century Silicon Valley. They slept under tables and pulled all-nighters to ship products and make quarterly revenue–all because it was “our” company.

 While founders had more stock than the other employees, they had the same type of stock options as the rest of the employees, and they only made money when everyone else did (though they made a lot more of it).

Back then, when earlier angel and seed funding didn’t exist to get the company started, founders put a lot more on the line– going without a salary, mortgaging their homes, etc. This “we’re all in it together” kept founders and employees aligned on incentives.

What does vesting mean –

The employees don’t get to own all these options all at once. Rather they receive parts of it which until a certain time frame gets full.

For eg – For a 5 year period, every month a 1/60 th part would trickle down to them of the entire option grant.

Talking about rationality back then –

The founders, all the employees and the later employees and investors had the same vesting deal. No one made money until a liquidity event happened. The rationale was that since there was no way for investors to make money until then, neither should anyone else. Everyone—investors, founders, and start-up employees—were in the same boat.

Having said that – The founders got the most options, the employees got fewer and the later ones even fewer hence making the math really same for all the participants in the company.

But you might point out that’s still happening now, isn’t it?

Then let’s focus on what has changed…

The Problem isn’t in the way the vesting is or the way stock options are. The circumstances which have transformed stock options from a amazing strategy to being worth actually nothing is because of the way the industry has transformed.

Talking about the changes that matter…

The amount of money Venture Funds have raised in the past 2 decades –

This amount of money has not been raised since the dot com craze in the United States. The industry is again getting into an overcapitalized state but this time it’s even worse.

Talking about our villain –

“THE RISE OF MEGA ROUNDS AND MEGA GROWTH FUNDS……. “

Let’s say these words again with a devil’s laugh, shall we ?

If you look one layer deeper at what has happened in the Venture Capital industry the funding increases have gone overwhelmingly do “mega rounds” of late stage investments with round sizes of $100 million or more. In fact, the “traditional VC” market has only grown 14% per year and mega-rounds now account for nearly half of the dollars in the industry.

If you look even more closely you’ll see just how skewed the data really is. $21 billion of funding last year (16% of the market) came from deals in which investors put in $1 billion or more and a whopping $40 billion came from deals of $100 million or more. Taken together these “mega rounds” represent nearly half of the funding in 2018.

Note - I have chosen to define “growth rounds” as rounds of $100 million or more but if you include deals of $50 million or more (traditional growth or mezzanine rounds) this accounts for 62% of the entire start-up funding market.

In the last few years, these growth rounds have significantly increased and the total funding in the companies from the private investors has also take an exponential increase.

Talking about the startups 50 years ago to 2010–

The main facts gathered from these companies. A simple look at data shows that at IPO (or exit) founders keep around 10% of their company whereas investors own 50% and employees 20%.

The remaining 20% goes to the general public at IPO. It is wrong when to have claimed founders and investors would split equally! Of course, this is a little too simplistic. For examples founders keep more in Software and Internet startups and less in Biotech and Medtech.

There could be a lot more to add but I let the reader focus on what possibly interests her. Additional interesting points are: The average age of founders is 38 but higher in Biotech and Medtech and lower in Software and Internet. It takes on average 8 years to go public after raising a total of $138M, including a first round of $8M in VC money.

The average years to IPO in up to around 2010 were only 8 years for successful startups.

Here’s a detailed brief on the kind of startups who were considered the most successful back then.

Talking about Startups considering growth funds now –

In the 20th century, the best companies IPO’d in 6–8 years from startup (and in the Dot-Com bubble of 1996–1999 that could be as short as 2–3 years.)

One other thing to note is that all employees — founders, early employees and later ones — all had the same vesting deal — four years — and no one made money on stock options until a “liquidity event” (a fancy word to mean when the company went public or got sold.) The rationale was that since there was no way for investors to make money until then, neither should anyone else.

Here’s the Big Change –

Instead of a start-up going public six to eight years after it was founded to raise capital to grow the company, today companies can to $50M+ funding rounds is a deferring the need for an Initial Public Offering to 10 or more years after a company is founded.

The first big idea is that unlike in the 20th century when there were two phases of funding startups–Seed capital and Venture capital–today there is a new, third phase. It’s called Growth capital.

Now this is a big change because, Start-up Compensation Changes with Growth Capital — 12 Years to an IPO

The longer the company stays private, the more valuable it becomes. And if during this time VC’s can hold onto their pro-rata (fancy word for what percentage of the startup they own), they can make a ton more money.

The premise of Growth capital is that if that by staying private longer, all the growth upside that went to the public markets (Wall Street) could instead be made by the private investors (the VC’s and Growth Investors.)

Salesforce, Google and Amazon — show how much more valuable the companies were after their IPOs. Before these three went public, they weren’t unicorns — that is their market cap was less than a billion dollars.

·       Before these three went public, they weren’t unicorns — that is, their market cap was less than $ 1 billion.

·       Twelve years later, Salesforce’s market cap was $18 billion, Google’s was $162 billion, and Amazon’s was $17 billion.

It isn’t that startups today can’t raise money by going public, it’s that their investors can make more money by keeping them private and going public later — now 10–12 years. And currently there is an influx of capital to do that.

A graphical representation of this change would be –

Considering the companies like Salesforce, amazon and google – They weren’t even unicorns before going public. Ask yourself how many private unicorns do you see now?

What has this to do with ESOPs? Here’s what…………

The emergence of Growth capital, and pushing an IPO out a decade or more, has led to a dramatic shift in the balance of power between founders and investors. For three decades, from the mid-1970s to the early 2000s, the rules of the game were that a company must become profitable and hire a professional CEO before an IPO.

That made sense. Twentieth-century companies, competing in slower-moving markets, could thrive for long periods on a single innovation. If the VCs threw out the founder, the professional CEO who stepped in could grow a company without creating something new. In that environment, replacing a founder was the rational decision. But 21st century companies face compressed technology cycles, which create the need for continuous innovation over a longer period of time. Who leads that process best?

Often it is founders, whose creativity, comfort with disorder, and risk-taking are more valuable at a time when companies need to retain a start-up culture even as they grow large.

With the observation that founders added value during the long run-up in the growth stage, VCs began to cede compensation and board control to founders

How have stock options evolved?

While founders in the 20th century had more stock than the rest of their employees, they had the same type of stock options. Today, that’s not true. Rather, when a startup first forms, the founders grant themselves Restricted Stock Awards (RSA) instead of common stock options. Essentially the company sells them the stock at zero cost, and they reverse vest.

In the 20th century founders were taking a real risk on salary, betting their mortgage and future. Today that’s less true. Founders take a lot less risk, raise multimillion-dollar seed rounds and have the ability to cash out way before a liquidity event.

Early employees take an equal risk that the company will crater, and they often work equally as hard. However, today founders own 30–50 times more than a startup’s early employees. (What has happened in founder compensation and board control has mirrored the growth in corporate CEO compensation. In the last 50 years, corporate CEO pay went from 20 times an average employee to over 300 times their compensation.)

On top of the founder/early employee stock disparity, the VC’s have moved the liquidity goal posts but haven’t moved the vesting goal posts for non-founders. Consider that the median tenure in a startup is 2 years. By year three, 50% of the employees will be gone. If you’re an early employee, today the company may not go public until eight years after you vest.

So why should non-founding employees of startups care? You’ll still own your stock, and you can leave and join another startup. There are four problems:

• First, as the company raises more money, the value of your initial stock option grant gets diluted by the new money in. (VC’s typically have pro-rata rights to keep their percentage of ownership intact, but employees don’t.) So while the VCs gain the upside from keeping a startup private, employees get the downside.
• Second, when IPO’s no longer happen within the near time horizon of an employee’s tenure, the original rationale of stock options — offering prospective hires a stake in the company’s future growth with a visible time horizon of a payoff for their hard work — has disappeared. Now there’s little financial reason to stay longer than the initial grant vesting.
• Third, as the fair market value of the stock rises (to what the growth investors are paying), the high exercise price isn’t attractive for hiring new employees especially if they are concerned about having to leave and pay the high exercise price in order to keep the shares.
• And finally, in many high valued startups where there are hungry investors, the founders get to sell parts of their vested shares at each round of funding. (At times this opportunity is offered to all employees in a “secondary” offering.) A “secondary” usually (though not always) happens when the startup has achieved significant revenue or traction and is seen as a “leader” in their market space, on the way to an IPO or a major sale

The End of the High-Commitment & High-Performance Work System?

In the academic literature, the work environment of a startup is called a high-commitment/ high-performance work system. This is a bundle of Human Resources startup practices that include hiring, self-managing teams, rapid and decentralized decision-making, on-boarding, flexible work assignments, communication, and stock options. And there is evidence that stock options increase the success of startups.

Successful startups need highly committed employees who believe in the goals and values of the company. In exchange for sharing in the potential upside — and being valued as a critical part of the team, they’re willing to rise to the expectation of putting work and the company in front of everything else. But this level of commitment depends on whether employees perceive these practices to be fair, both in terms of the process and the outcomes.

VCs have intentionally changed the ~50-year-old social contract with startup employees. At the same time, they may have removed one of the key incentives that made startups different from working in a large company.

While unique technology or market insight is one component of a successful startup everyone agrees that attracting and retaining A+ talent differentiates the winners from the losers. In trying to keep companies private longer, but not pass any of that new value to the employees, the VC’s may have killed the golden goose.

Note – Please use this document as a reference and not as an advice. The data might be subject to some bias. This is merely my (Darshit Jain’s opinion) and nothing more. All kinds of criticism are welcome.

References –

1.     https://arxiv.org/ftp/arxiv/papers/1711/1711.00661.pdf

2.     dramatic shift in the balance of power

3.     https://hbr.org/2019/04/how-to-make-startup-stock-options-a-better-deal-for-employees

4.     https://bothsidesofthetable.com/a-deep-dive-into-what-has-really-changed-in-venture-capital-f5d225f7f8

5.     https://www.slideshare.net/msuster/is-vc-still-a-thing-final?qid=ebbded0d-bb24-4af5-b11b-8be66e831f7

6.     https://carta.com/blog/employment-tenure-startups/

7.     https://500.co/founder-equity-101/

8.     The Fairchild Chronicles - silicongenesis.stanford.edu/transcripts/chronicles.htm

9.     High Tech Start Up. John L. Nesheim Free Press. 2000

10.  Wikipedia on stock

11.  en.wikipedia.org/wiki/Stock, common stock

12.  en.wikipedia.org/wiki/Common_stock preferred stock

13.  en.wikipedia.org/wiki/Preferred_stock, and Employee Stock Option Plan (ESOP)

14.  en.wikipedia.org/wiki/Employee_stock_option

15.  Transcript of oral panel – the Pioneers of Venture Capital – Don Valentine, founder of Sequoia Capital. Computer History Museum. September 2002.

16.  Equity Split in Startups. July 2017 - www.slideshare.net/lebret/equity-split-in-startups

17.  Equity Split in 400+ Startups. August 2017 - short.epfl.ch/equity-400startups

18.  Examples and synthesis of academic licenses to startups. May 2010 -www.slideshare.net/lebret/examples-and-synthesis-of-academic-licenses-to-start-ups-lebret

19.  Google Images

20.  Variety of articles on medium.com in the lights of both sides of the table.