Blog Post

It’s time to rethink startup equity

Change is the only constant in life and this is especially true in Silicon Valley. We live in a time of constant change and rebirth, which we optimists think is for the better. One thing hasn’t changed: How Silicon Valley companies — especially startups — use stock to compensate and incentivize their employees.

Traditional stock options are failing to create the ownership culture we want from employees and it’s killing our ability to build companies for long-term success.

For employees, a one-year term ending on the vesting cliff date is increasingly common. This leaves a big hole in the team and the cost to hire a replacement is significant. We all want to eliminate bad matches sooner, but it’s no surprise so many employees wait for the equity. Having more non-employee equity holders causes resentment among current employees doing the hard work to create stock value.

On the other side of the equation, founders and investors are increasingly tight-fisted with company ownership, allocating smaller stock pools to employees — most of which are eaten up by very early hires, rock stars or senior execs — leaving very small amounts for later hires, which does little to nurture their commitment to the company.

I’ve been involved with startups for a long time and have seen these patterns over and over. After working at a number of startups, I co-founded Equinix in 1998, Revision3 in 2005 and was the chief executive of Digg, Revision3 and SimpleGeo. I’ve also been an active advisor to several early-stage startups. After nearly twenty years of using the same recipe for employee equity, I’m taking a new approach at my new startup, Opsmatic. We are sharing equity in a new way, one we believe builds a true ownership culture that will be a key to our success.

I’ll explain more later, but in addition to a traditional stock option grant, we’re offering our first fifteen employees, or however fewer it takes to get to the next financing, an equal share of 15 percent of the company, which they will receive if they stay with the company through a liquidity event.

Why do this? We are focused on attracting and retaining the best possible team over the long term. Our employees are key to our success, and we are determined to change their (and our) behavior to avoid the downsides of the traditional approach to stock allocation. As I talk to CEOs, I’ve uncovered some of the causes of these patterns.

Employee behavior

Burned by booms and busts, employees often look to maximize their compensation up front, hopping from company to company in an attempt to scale compensation or title. Most stock options have a one-year cliff; if they leave at that point, they can purchase 25 percent of their equity with no further commitment to the company, giving them the ability to diversify their equity portfolio and reduce risk.

The rise of secondary markets has complicated matters and created a pervasive myth that employees can sell their stock early. While private stock sales are available to a minority of high-value, successful companies that support these transactions, it’s not an option for most early companies. According to SecondMarket’s 2012 data, the median number of employees for companies with private stock transactions was 347 with an age of seven years and a market cap of $569.5M, and 66 percent of transactions were made by existing employees, not former employees.

Founder behavior

Founders and CEOs typically distribute equity in a long tail, most of which goes to very early employees after a first financing, leaving increasingly smaller amounts for later hires. This does not build a sense of shared ownership.

The rationale I hear is that early employees take more risk around an uncertain future, so they should get higher compensation. Lately, in conversations, I surprisingly found that people joining later often feel they are taking a larger risk around getting paid!

This may seem backward, but upon reflection, there’s always the non-trivial chance of the next round not happening or revenue not coming in before cash is burned away. A fresh, recently funded startup has more money in the bank and has made fewer execution errors, so risk is a matter of perspective.

To make matters worse, I’ve talked to dozens of founders who confirmed that in retrospect, there was little correlation between the distribution of stock options and the actual value the employee brought to the company. Independent of contribution, the larger option packages are dolled out to super early employees (or co-founders) and rock stars.

A rock star hire is a hire in which founders and CEOs pay above market rates for someone they deem super-critical. Maybe you’re developing software and would benefit from someone who is famous for inventing the concept. Perhaps you need to build a new sales force, so you go after a famously successful head of sales veteran from another company. Maybe you want to recruit new talent, so you hire someone that new employees would kill to work with.

Rock stars are typically fought over, so equity distribution increases due to competition, giving these employees a larger share. Nevertheless, years later, post exit, often the unsung heroes — like employee number fifteen — weren’t benefiting in a way that reflected their contribution. As far as I’m concerned, when combined with the long-tail distribution, this is not the best way to motivate employees or engender team loyalty.

The details of our approach

To address these issues, we’ve created a new approach to equity called the Dynamic Stock Pool (DSP).

This pool is designed to be a long-term incentive, encouraging loyalty and reinforcing that we will win or lose as a team. While each of our employees will get a traditional stock option grant, the majority of Opsmatic’s employee stock — 15 percent of the company — is allocated to the DSP.

The DSP pool is egalitarian, shared equally amongst the first fifteen employees we hire. So it’s a rich incentive at 1 percent of the company (before any future dilution). Typically, equity numbers of that level are reserved for VPs, CxOs and rock stars, so this is a significantly more generous offer than most early hires receive, particularly outside of management or founders.

However, here’s the catch: The stock in this pool is only distributed to employees who remain at the company through a liquidity event, such as an IPO or acquisition. If you leave before then, you don’t get any of your DSP shares — so this is truly an incentive to play for the long-term. In fact, the employees who stay through the liquidity event continue to share equally in the pool. For example, if only five of the first fifteen employees remain, each would receive 3 percent (pre-dilution).

What about…

Clearly this is different from how things have been done since companies started handing out stock options, so of course it raises a few questions.

Some feel that varying skills and experience merit differential grants. Beyond accompanying salary differences, we also have a traditional option pool to address a legitimate reason to give one employee more than another. Another challenge involves the perception of the ‘value’ of different kinds of employees. For example, some people have asked, “What if you hire a receptionist or a janitor? Should they have as much value as a developer?” Because each employee is equally diluted in the DSP, this model creates a strong incentive to only hire critical employees. This means hiring fewer non-essential personnel and prioritizing the hiring of great, mission-critical people first. If your team truly needs a receptionist to succeed, the equity is justified. As for early departures, employees who unexpectedly leave would still have their traditional vested options, and measures are in place to prevent a manager from firing someone at the end, like a game of Survivor.

There are other edge cases we have thought of and resolved, and probably complications that arise out of the longer-term nature of this incentive. However, I spent the greater part of two years working with great attorneys closing all the legal loopholes that may arise, and I’m confident enough that I’m using Opsmatic as the first test bed for the DSP.

Of course, I welcome feedback, and I’ll definitely share what I learn as we put this new approach to work.

Jay Adelson is a serial entrepreneur, having built companies such as Equinix, Digg, Revision3 and SimpleGeo. Jay founded Opsmatic in early 2013, and currently serves as Chairman and Founder.

Featured photo courtesy Shutterstock user Shutterstock user AnatolyM

30 Responses to “It’s time to rethink startup equity”

  1. Mark Gritter

    Have you considered the implications for the death of an employee? Even young people die, and I would be displeased to have a major portion of my equity compensation unavailable for my wife or other heirs.

  2. You left one topic unfinished. So, you later (after the first 15 and after second financing want to hire a rock star SVP of sales. This person has needs (salary and stock) that are significantly higher than your scale. She is a person who could move mountains and take your company to the next level. Do you create the *exception* knowing she is compensated higher than early folks who built the place? Does the chance to raise the tide for everyone warrant such a move? Whats fair?

  3. Dave DuPont

    I believe the problem Jay is trying to address is a peculiarly Silicon Valley issue. Boulder, where my company is headquartered, has a thriving entrepreneurial community but I have never heard about anyone jumping after the one year option cliff. I would like to believe that perhaps we are more focused on building long term value and on providing an experience employees want to continue to be part of. Striking it rich through options is part of the picture, especially for the earliest folks who often take enormous risks to realize a vision. It is not by a long shot, however, even for those earliest employees, the most important factor.

  4. I second the request to make some of your docs public. I am in an early stage of a start up, just 3 employees. I like your DSP solution but would not be able afford the legal paperwork right now. It would be a huge help if there were some documents to help us incorporate the properly set up. Thanks for the article and sharing you knowledge.

  5. Silicon Valley obviously works a little differently to UK startup incentives, Over here, there are two norms: 1) that no stock options vest until a liquidity event occurs; or 2) occasionally for tax scheme purposes, where performance related stock options are granted that have pre-liquidity vesting rights, that the board has a claw-back clause for leavers allowing the company to acquire the stock back at the current pre-market /notional value. Both methods seem to keep everyone focused on the big prize, and certainly in my experience, it’s very rare for employees to want to leave before a trade sale or exchange listing.

  6. Tax issues ? If equity is reallocated later between continuing employees due to early employees leaving, are there valuation aspects that may release tax obligations due to increase in value of the stock ?

    • jayadelson

      Actually, one of the benefits of this is that no, there are no surprise tax obligations. The shares themselves are not allocated unless a liquidity event occurs, and the calculation of shares is made at that time. Because of this, no asset changes hands, and there is nothing tradable until that point. The disadvantage of this is short term gain tax treatment, but on the flip side, we expect a typical employee will get 10x what a traditional option might give them, particularly if you’re employee 15 or higher.

  7. jayadelson

    I should point out that the DSP is designed to be replicated at successive financings, e.g. DSP 2 at Series A, DSP 3 at Series B, etc. Future employees also get to participate, but it’s more of a stepping function than a long tail.

    Also, a very critical thing to remember is that employees also get regular vesting stock options as well. We’re not saying there isn’t value in vesting, there is. However, we don’t want to dis-incentivize long-term thinking.

  8. I joined a startup at a relatively late stage (employee 18) and by now I’m one of the most ‘senior’ employees still standing, where seniority is measured in how long people have been around. Your argument makes me practically ‘worthless’, because I wasn’t around from the very beginning. Even by the traditional rules of allocating equity, no matter how much value I could generate or demonstrate at this stage, my equity share will never get close to those who joined the same business entity (which by the way has transformed a lot to a whole different business by now) just a year earlier.

    So perhaps my perspective is a bit biased.

    1) Your solution puts even more weight to early stage employees and it’s even more black and white. Sure, you’ll need very dedicated/motivated people in the first stages before your company grows to 15+ employees, but you’ll probably need different skillsets later on. A startup is about learning, and sometimes changing course or pivoting, and you will have no gunpowder left to fuel hiring around these critical pivots.

    2) Each person’s contribution exhibits diminishing returns property. Having a person staying for 4 years is not twice as valuable as having them stay for 2 years. Do you really want people to stick around for the entire 5-10 years it takes until the liquidity event in the first place? Is this really the key to success?

    Most entrepreneurial people (the type of people you want to hire) will naturally want to move on at some point, they are motivated by learning new things. In fact learning things is one of my primary motivation for working at a startup. Eventually they will feel they are not learning/contributing that much anymore, and it’s perhaps best if they are not locked in by the equity incentive scheme. If there are conflicts in your team, you don’t want to end up in a situation where neither of the conflicting parties wants to leave because they would make the other party a favour.

    Perhaps it’s best for you to embrace the concept that people will want to move on, assume this will happen and build a culture and incentive system in which moving on is accepted and recognised. At the end of the day you want each and every ex- and current employee’s equity stake to represent the ‘value multiplier’ that their work resulted in, whether they joined early or late. Naturally, it’s easy to think that people who joined earlier took more risks, and they added more value, but I think this in itself can be a misleading argument.

  9. geraldw522

    I love this idea — it aligns very well with how we plan on growing/financing our company CompilerWorks. Any chance of getting a legal “template” rather than having to pay lawyers to re-create what you have done already?

  10. There is a conflict of interest here if any of the first 15 employees report to each other, sacrificing an unpopular employee through termination increases the reward for those left over. This could place a lot of stress on early employees with regards to their job security, as their peers and manager would benefit from their departure.

    • jayadelson

      We’ve prevented that scenario with language, but the conflict of interest issue raises an interesting point: If the team is focused on the stock having value in the future, inappropriate team management/firing hurts that value. Having more of nothing isn’t in anyone’s interest.

  11. emotivation

    Jay, how are you addressing the zero-sum nature of the awards? Participants in the DSP each have an incentive to reduce the pool size, which conflicts with the goal of long-term teamwork.

    • jayadelson

      Great question. We had to embed elements which dis-incentivize managers with firing authority to cut an employee prematurely. Part of this has to do with proper leadership of the organization, because if that happens you’ve got the wrong person with that authority. As I mention, we’re taking pains to make sure this doesn’t end up a game of Survivor.

  12. Kudos on innovating in this area. It is an area much in need of disruption. What are the chances you’ll make your docs Open Source so the community can evolve and improve them?

  13. kabbenbock

    Thanks for a thoughtful and clear explanation of a complicated concept, Jay. You certainly have experienced the challenges of employee equity distribution many times over.

    The Valley could certainly use something like your DSP to adjust for the distortive unintended consequences inherent in traditional startup compensation plans.

    Since this is an ambitious hypothesis you are testing in real life, what metrics are you capturing and applying to determine the program’s effectiveness as you go?

    • jayadelson

      There are a few things we’re measuring. First off, obviously, is employee term length, which will take a while to measure. Second, the direct feedback during the recruitment process. So far, it’s been a major selling point, but it also filters out short-term minded prospects. Third, we’re qualitatively measuring the nature of how we determine when, and who gets hired next. We’re open to suggestions on other measures!

  14. A suggestion, If a person in first 15 quits should the guy in 16th place get the 1% ? Does this make it better or worse ? and FOUNDERS succeed when all the 15 quit ;) ..

    • jayadelson

      It’s a valid point, but what we are hoping to do is create successive DSP funds timed around financings. This way, the first 15 or so are in fund 1, the next 30 in fund 2, etc. Still, if #15 drops out, yes, #16 gets a benefit. If there is no #16, everyone anti-dilutes equally.

      • George Marshall

        Related to this, how will #16 benefit if #15 drops out? In the article it says, “if only five of the first fifteen employees remain, each would receive 3 percent”, so the 15% is accounted for.

  15. It’s interesting that that you believe the DSP will cause organizations to consider the value of a hire and force only critical hires, but in practice you will hire a janitor, office manager or receptionist – only they will be a second class of employee, like a temp or contract-hire.

    • jayadelson

      I understand your point, but actually we believe the opposite will result. If you hire a receptionist, it’s because you really need one to succeed or for your image…I don’t think there is any harm in giving them a fair shot. Some of my most worthy employees who worked the hardest and deserve reward were not engineers or VPs.