All the debate and discussion -- and the eventual move last year by the accounting profession to make stock options count as an expense against profits -- is percolating down to early-stage startups. Suddenly, options aren't the obvious choice for employers wanting to use company equity as a way to attract top-flight talent.
ALLOCATION TUSSLE. The diminished status of stock options is, at first glance, unfortunate for today's fast-growing companies. Venture investors have been comfortable with stock-option programs as a cash-free way to create incentives, with the added bonus that options have been free of any financial accounting penalty.
Coming up with new incentives that venture capitalists accept is no simple task. An inherent tension exists between entrepreneurs and venture capitalists over the allocation of equity. While both sides invariably say they want the founders and management team to have enough equity to keep everyone motivated, the amount each side considers "enough" usually differs. Not surprisingly, entrepreneurs want to see more equity staying with founders and management than do the venture capitalists.
When entrepreneurs put together stock-option programs, they typically set aside 10% to 20% of the business' equity for options, available to key employees on a vesting schedule usually ranging from three to five years. These options have been set aside in addition to founders' stock.
WIN-WIN DISTRIBUTION. Now, as the professionals like to say, a level playing field has been created between options and other types of equity. This actually offers an opportunity to establish a flexible and balanced portfolio of equity offerings -- a menu of different types of equity vehicles that provide the right combination of incentives to key employees in various demographic groups, career paths, and performance objectives.
If properly structured, these equity incentives result in a "win-win" situation: Providing more meaningful performance impetus and higher value to recipients, while minimizing the percentage of equity committed to employee stock incentives.
This new suite of equity incentives includes the following components:
1. Restricted stock
These shares are handed out on a basis that's the reverse of stock options. A key person receives an agreed number of shares and under a vesting schedule that requires the return to the company of a certain percentage of the shares if the employee leaves early. For example, if the stock vests over four years, the individual might have to return all the shares for leaving before year one and three-fourths for leaving before year two.
Restricted stock can also be issued for free or for full value, for meeting performance objectives, or in a matrix of time-based and performance-based systems. One big advantage of restricted stock is that it often qualifies for capital-gains treatment, while options can incur higher ordinary income tax rates on gains that occur from the time they're awarded to when they're exercised.
2. Phantom stock
These "synthetic equity" awards range from simple cash bonuses tied to increases in an outfit's equity valuation to comprehensive programs linked to various performance objectives and subject to the same vesting schedules as options and restricted stock. From an employer's perspective, the awards don't dilute "true" equity, while still giving employees an equity-like incentive.
3. Stock options
Yes, stock options. The fact that other equity approaches are gaining popularity doesn't mean that stock options are completely out of fashion. They remain the best-understood model for entrepreneurs and venture capitalists. Because of the new financial penalties they incur, though, they can be expected to hold dwindling prominence -- and account for a smaller percentage of equity-incentive programs.
If properly structured, a blend of equity and synthetic-equity incentives can reduce the overall percentage of the business' stock reserved for key employees from the 15%-to-20% range customary for stock-option plans to approximately 10% to 15% of total capitalization. This is equally attractive to founders and venture capitalists.
The emergence of these more comprehensive equity packages will likely force entrepreneurs to set up and improve their systems and methods for awarding equity. These can be based on the importance of particular management positions, when an individual joins the team, and the background/experience of team members. Venture capitalists usually welcome improved systems. Garai is a partner in the Boston office of national law firm Foley & Lardner, specializing in venture capital and private equity