This month, transport behemoths Uber and Lyft both announced that their most loyal drivers would be receiving shares as part of their IPOs. Given that these individuals are (literally) the driving force behind the businesses, this shouldn’t come as a shock. But too many European startups don’t handle stock options properly.
Top talent must be attracted in order for startups to flourish, but the risks are high. It’s a savvy founder, therefore, who looks beyond the patronising offers of table tennis and beer on tap and offers up stock options instead. However, there are common mistakes to avoid:
1) When staff resign, they should keep their options - don’t try and fight it
Why give staff options? Top of most companies’ motivations is retention.
‘Vesting’ arrangements, under which options only fully mature over a certain number of years, are designed to ‘lock in’ staff to a business and ensure that if they leave they have to forfeit something valuable.
However, many companies make a fundamental mistake by saying to staff that if they leave they lose everything. These firms mistakenly think this increases the power of retention options hold.
In truth, ‘leave and lose’ actually weakens the power of options.
In truth, ‘leave and lose’ actually weakens the power of options.
Savvy staff will know that ultimately their stock options might be worthless if they choose to leave the business (possibly for reasons beyond their control, such as a family move) or if, even worse, the business gets rid of them. Staff are understandably going to mentally discount the value of any options they might entirely lose for circumstances beyond their control.
A well-designed scheme recognises that the vesting schedule is the retention incentive, but that options once vested are kept — even if the valuable team member quits for a better offer. With a poorly designed scheme, options have no credibility and nor do the firms offering them.
2) Know how far is too far with accelerated vesting
Vesting is the point at which employees have unconditional rights over their stock options. Acceleration, in which vesting ‘speeds up’ if the company exits, is important for several reasons. The main one is to align staff with investors. Without it, staff with very few options vested may prefer a £100m exit in two years' time, compared to a £300m exit next month before their vesting kicks in. They could even work to frustrate an exit, even one which the investors would dearly love to happen.
Well-designed schemes typically offer at least enough acceleration to cross any ‘cliff’ period, so that all options holders receive something even if they joined the company a month before (as happened to someone I know, who joined Skype weeks before it sold to eBay in 2005). This ensures all option holders have at least some incentive to row in the same direction.
But accelerated vesting only makes sense to a point. Full acceleration can be quite off-putting for any buyer because they face the prospect of a mass walkout (normally to a tropical beach) immediately after the deal closes.
A sensible compromise is partial acceleration, either ‘time based’ (e.g. “an exit winds the clock forward by two years”), or fractional (e.g. an exit will vest half of any unvested options). This ensures all option holders are disproportionately motivated by successful exits, but ensures there is some retention incentive left in the tank after the deal.
3) Beware of ‘free’ options
Stock options provide the right to buy shares at a certain price; after exercising the option the holder then has actual shares.
Companies are often tempted to give staff options with a ‘strike price’ of the lowest amount allowed, such as £0.01p. This ensures that options feel as similar to shares as possible, once they vest.
Investors will often resent getting diluted by staff option schemes. If there is a tangible strike price, it reduces the dilution.
However there are downsides to having vested options treated as ‘free shares’. Suddenly there can be hundreds of tiny shareholders in the business. Worse still, the company might have a legal obligation to communicate with all these shareholders during sensitive times such as a possible acquisition. At such points in time, when managing the communications with existing loyal staff is tricky enough, you don’t want to have to mail hundreds of former staff first.
Secondly, investors will often resent getting diluted by staff option schemes. If there is a tangible strike price, it reduces the dilution benefit to those investors, ensures that more of the options come back into the pot when people leave, and aligns interests better with value created, rather than just ‘free money’.
4) File your EMIs and s431 notices properly
For companies often run by some of the country’s brightest minds, the frequency with which startups mess up their compliance obligations is staggering. In the UK, Enterprise Management Incentives (EMIs) are a tax favourable way of receiving options and is used by the vast majority of startups when structuring staff options schemes. But companies need to issue within 60 days of receiving HMRC approval or else lose EMI status.
Another common trap is to forget to file a s431 notice when leaving a company (or otherwise losing EMI status, e.g. by becoming part-time) or exercising an option, which is required to optimise the tax treatment of options. It’s good to get professional advice on these areas if you want to avoid a stinging call from the tax officials at HM Revenue and Customs.
5) Know why and how you’re valuing the shares
When you think of owning shares in a company, the stock market sets the tone. With public companies, it is fairly easy to work out what shares are worth — you can look up the price of them online or in a newspaper. But with private companies it can be a lot harder, especially with stock options where the strike price may be quite a high number.
Unscrupulous CEOs often deliberately obfuscate the value of stock options, and invite staff to believe that options are worth what shares are worth. One CEO I know gave staff options with a strike price of the latest share price, and told staff they were worth that price. This was borderline fraudulent behaviour; if there is no change in the company’s share price, those options are in fact worth zero.
If Amazon’s share price is $1,700, and you have the right to buy it for $1,700, what is that worth? It depends on how long that right lasts.
If Amazon’s share price is $1,700, and you have the right to buy it for $1,700, what is that worth? It depends on how long that right lasts, and what you think will happen to Amazon’s stock price. If the option lasts a week, it is probably not worth much. If it lasts 10 years, it is worth something.
Ultimately there is no right answer to what stock options in fast-growing businesses like Deliveroo, Monzo or Goodlord are worth. But as the CEO awarding your team stock options, make sure you don’t set expectations that come back to bite you when the company exit is not quite at the fairy tale levels you’d all hoped.
William Reeve is CEO of Goodlord, and previously founded LoveFilm, the DVD-by-post service that was acquired by Amazon in 2011.