Startup Life/Opinion/

Six pitfalls to avoid when negotiating employee stock options

Many startup employees give up part of their salary for a share in the company’s long-term success. Here’s how to negotiate your equity package.

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Martin Schilling and Thomas Klugkist

By Martin Schilling and Thomas Klugkist

The startup life promises much: personal development, autonomy, the chance to build a company that changes the world for the better. What it often cannot promise is the highest salary. This is why many startups offer employees a slice of the pie in the form of an Employee Stock Option Program (ESOP). Employees accept a lower base salary in exchange for ownership of the company — and a rich reward if the startup goes public or is acquired. 

In Europe, an ESOP deal can come in different forms, such as a “Virtual Employee Option Program” or an option program that grants employees the right to buy stocks when they leave the company at a discount from market prices. 

Startups in Europe are offering more equity as the war for talent heats up. And more employees are understanding their value as the success of the first generation of European tech companies shows how lucrative equity can be. But such agreements can be notoriously difficult to understand, especially for people just starting out in the tech world. Here are six errors to avoid when signing an ESOP.

Keep an eye on your vest length

The logic of share vesting: the longer you work for the company, the more shares you receive. This arrangement is designed to prevent employees from exiting the company too soon. Shares usually vest monthly, quarterly or bi-annually until the end of the fourth year of employment, when the employee becomes eligible to receive all their shares.

If you have a strong track record as a leader or have substantial experience, you could negotiate your vesting time frame down to three years, as too long of a vesting period will keep you locked into the company. Ideally, you should agree on monthly rather than quarterly or annual vesting. 

Watch out for the cliff edge

Typically there is also a vesting cliff, an initial cut-off after which employees are eligible to receive any shares at all (usually a year). The cliff is the period you need to wait until you receive stock options. If you have a one-year cliff, all your options from the first 12 months will vest collectively at the start of month 13. From that point on, you will receive your shares on a monthly or quarterly basis depending on your agreement.

A 12-month cliff is the industry standard. You may be able to negotiate this down, but only in exceptional circumstances. 

Keep strike prices down

If an employee joins a startup in its early days, their reward should be worth more than someone who climbs aboard later on. This is why a strike price exists: it prevents latecomers from being rewarded for the value others have created. 

Say when signing your contract that each share is priced at $1k, meaning you have the right to buy the shares later on at that price, regardless of what they are worth in the market. If the company is bought four years later and the price has risen to $20k per share, the value you have co-created is $19k — the current share price ($20k) minus your strike price ($1k). In the case of an exit event, you will receive $19k for each share. Having this logic in place is normal and fair. 

Be sure to use the strike price of the last funding round. There are cases where your strike price may be higher, but you should only accept this if there is clear evidence of a higher current share value, such as a signed term sheet from a new investor with a higher valuation.

Spread the load equally

If you have an extended vesting time frame in place, larger volumes of shares are sometimes allocated later on (“back-loaded”). Startups such as the social network Snap or the ecommerce company Farfetch have such vesting schemes in place to incentivise team members to stay for as long as possible. Instead of giving employees a fourth of their options per year, these companies may give 10% in shares in the first year, 20% in the second, 30% in the third and 40% in the fourth. 

Negotiate for a vesting scheme that vests the same amount of shares per year rather than a “back-loaded” scheme. Be aware, though, that it is often difficult to campaign against the company’s standard scheme in the event that the vast majority of staff have already accepted it. 

Need for speed

In case of an exit or a change in ownership, an employee stock ownership package may contain a clause in which all unvested shares are allocated to employees at once. This encourages them to stay with the company throughout the ownership change or exit. On the other hand, it may eliminate the incentive to stay after the exit and could increase risk on the part of the acquirer. Despite this, according to Index Ventures, one-third of European startups offer full accelerated vesting to all employees. 

It is advantageous to negotiate an acceleration clause in your contract, especially if you are part of the senior leadership team. 

Have one eye on the door

If employees leave before the company goes public or is sold, can they keep their options? Half of European startups allow employees that leave to keep their vested options — but do not allow them to exercise this option until the exit occurs. How about if you break the law and are fired, e.g. due to fraud? This makes you a “bad leaver”, meaning you need to transfer back all shares — and rightly so. 

A fair option is for employees to keep their vested shares when they leave, but ensure they can sell them only if a float or a trade sale occurs. Be aware of “bad leaver” clauses: if you decide to leave the company of your own accord or your boss fires you due to performance issues, the company may ask you to transfer back all shares. Ideally, you shouldn’t sign such an agreement.

Put simply, a talent-friendly ESOP agreement would consist of a vesting scheme of four years with a strike price based on the last funding round, monthly vesting, a one-year cliff, an acceleration clause for senior colleagues and a leaver clause that allows you to keep your vested shares until a potential exit occurs.

 

This article is an abridged version of a chapter from the book “The Builder’s Guide to the Tech Galaxy — 99 Practices to Scale Startups into Unicorn Companies”.

Martin Schilling is an author, investor, entrepreneur and former COO of fintech N26.

Thomas Klugkist is an author, media and communications manager and a consultant for scaleups.

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