Careful About Equity and Options in Early Stage Businesses

This post is longer than usual. For those negotiating equity allocations it covers some of the most complex issues to address in the process. I just couldn’t reduce it to far fewer words… Dave

Here is the warning: The execution of partnership equity allocations and of a good incentive program using equity is often mismanaged, damaging the corporate capitalization structure and even affecting the outcome of subsequent investment into the company.

Here’s an example: First, a brand-new enterprise is often formed from the efforts of several “partners”, each with an expertise valued by the others. Equity is divided between the founders and the business begun. Although this insight does not address this point of ignition, we should note in passing that things always change over time, and formerly strong founder-contributors can become a drag upon a business or lose interest if the enterprise is not quickly successful.

To protect against this, there must be some document in place from the beginning that clearly states the expectation of each founder as to contribution of time and resources to the enterprise. The document should also contain clear buy-sell clauses, forcing any sale of shares to first be offered to the corporate treasury, then to the other founders in proportion to their holdings, and then if no interest, to outside investors. It should contain a mandatory sale clause in the event of separation of a founder, so that a major owner who is passive in the enterprise cannot easily vote against measures other active founders endorse.

And then there are options: Stock options or phantom stock are the tools of early stage businesses used to attract great talent when there is not enough cash to pay market rates. There are some rules. First you must create a stock option plan using your attorney, which must be registered in many states as a security offering. (The fee for registration is well under $100, so this is not an issue.) Options are usually best with “C” corporations, but granting options for either LLC’s or “S” corporations are not a real problem.

Most early stage companies make the mistake of making option grants to new hires at all levels that are too aggressive and distort the capital structure of the company to a degree that damages future professional investment. Let me try to advance a few rules of thumb to help guide you here. An option plan should carve out an addition of about 15% of the “fully diluted” shares. If there are 85,000 shares issued to the founders, then a plan calling for 15,000 shares in a pool reserved for future hires is appropriate, making the fully diluted shares 100,000. The board must approve the plan including this number, and shareholders must approve the plan as well. Each grant to new or existing employees must be approved by the board before issue.

How about the price per share? The price per share for option grants is also an important consideration. IRS rule 409a specifically calls for an appraisal of the value of the corporation’s stock current to within a year of any grants of options, although there is an exclusion for early stage businesses in which expert members of the organization or board may make such an appraisal if they qualify according to the exemption. If there is only one class of stock, the same as the founders, and the appraisal of the single class of shares yields, say $2.00 a share, then options must be priced at that amount. In other words, you cannot create bargain options at below “market rates.” If you have a preferred class of stock with special protections, that class of shares will be valued at a price higher than the founder common shares, allowing stock options to carry a lower price per share than preferred investors may have paid. This is important because high quality candidates should be induced to consider coming aboard at lower than market salaries using the tool of “cheap” options, properly priced.

How many options are appropriate for a grant? What percentage of the total company shares should be reserved for what specific job titles? Inducing a new CEO to come aboard usually means creation of a stock option package of 5-8%. That size of grant would take much or most of the option pool. A vice president, or CxO candidate, typically is offered between 1% and 1.5%. Director level employees are typically granted ½%. All other grants usually are much lower, allowing for the typical 15% pool to last for quite a while in most companies.

We will cover board members and advisory board members at a later time.

Options typically are earned over time, which we call vesting. If a grant of 10,000 shares is made on January First, typically there is a four-year vesting period in which the employee earns the right to exercise (buy) 1/48^th of the shares each month. Many plans also call for a one year “cliff” in which an employee who is separated from the company before a year is unable to exercise even the shares which would have been vested at that point.

Any other important considerations? There is an important consideration that will become an issue with sophisticated candidates for VP and above. We call these “trigger” provisions, in which selected options negotiated for a select group of senior managers, fully vest to 100% upon any change of control. This provision allows these select individuals to perhaps profit handsomely in an acquisition by being able to exercise their options in full at the time of sale. The negative side of this is that the buyer may not want to so enrich these managers that they may not be willing to come aboard the buyer’s organization, even if the existing options are replaced with options from the buyer company.

If all of this seems a bit overwhelming, we have just scratched the surface of option plans and incentive compensation. This is an area of expertise that a CEO is required to quickly learn and carefully manage with the help of the corporate attorney and the board.