A Different Approach to Refreshing Stock Option Grants

Stock Option Vending MachineEvery year in December and January I go through the same cycle for all the boards I’m on. It’s the annual bonus, next year bonus plan, option grant refresh cycle. For many management teams, especially in rapidly growing, or mature companies, it’s an important part of their existence as culturally we’ve oriented compensation, bonuses, and future compensation around an annual cycle.

I embrace this – my goal is to help these entrepreneurs and management teams win. I know compensation is an important part of the feedback / reward loop. While I’ve occasionally had conflict over compensation, and I’ve had a few CEOs I work with tell me they feel like it’s an uncomfortable discussion, my own perception of my behavior is that I’m a softy. If things are going well, I am supportive of anything that’s reasonable. And, having thousands of data points over the past 17 years, I’ve got a good calibration on reasonable.

One thing, however, has always baffled me. I’ve never really understood why the majority of stock option refresh grants are stacked grants mid-way through the granting process.

Let me give an example. Assume you hire someone and grant them 10,000 options with monthly vesting of four years with a one year cliff. That means that after one year, they get 25% of their options and then start vesting the remaining options monthly at a rate of 1/48 (208.3 options / month, or 2,500 / year.) On day 1 of year 3, the person has vested 50% of their options, or 5,000 of them and still has 5,000 left to vest. This person is doing great so management puts them in the annual option refresh cycle. Now, the company has increased in value, as has the option strike price, so the refresh grant is determined to be 25% of the original grant – or 2,500 options vesting monthly over four years, or 625 options per year.

Now, in year 3 the employee in question vests a total of 3,125 options, in year 4 they vest a total of 3,125 options, in year 5 they now vest 625 options, and in year 6 they vest 625 options. This makes no sense to me. You just changed their first four year vesting package from 10,000 options to 11,250 options (2,812.5 options per year) and then left them with 625 in years 5 and 6. This is a bonus in years 3 and 4 and a refresh in years 5 and 6.

Instead, why not grant them the new 2,500 options that vest in two years –  50% in year 5 and 50% in year 6. So now, they once again have 2,500 options per year for years 1 to 4 and 1,250 options vesting in years 5 and 6. This is a refresh in years 5 and 6.

The key difference is you are separating the “refresh grant” from a bonus, or retrading, of the hire grant. Now, I’m totally supportive of giving people bonus grants – if someone is doing an awesome job and they deserve more options in year 3 and year 4, do that. But that’s separate from a refresh, especially if your goal is to make sure there is always plenty of future options vesting.

The reason companies do the refresh in year 3 instead of year 5 is that – assuming success – the strike price of the option in year 3 will be lower. So the “value” of the option theoretically is higher if you grant it earlier since you get to lock in a lower strike price, especially against the uncertainty of where the strike price will be in two years. So that’s perfectly rational, but the idea of stacking the refresh grant on the old grant is not.

I’m not pushing to implement this in 2013 since I’m at the tail end of the refresh cycle with many of the companies I’m an investor in and just recently realized why the way refresh grants historically have been done didn’t make sense to me. And it shouldn’t make sense to the management team either – their goal and my goal is aligned – get plenty of future option value locked via vesting as a reward and retention tool.

I’m open to hearing why this doesn’t make sense. I just read it again and realize it’s confusing, as is almost every conversation I have with a management team around what, how, and why they are refreshing options. So – tell me what you do – and why – as I try to make this explanation / approach simpler.

  • Two comments – and neither necessarily run counter to your main point …

    First, if it’s confusing when you describe this concept to management, just think how confusing this is going to be to rank-and-file employees who, in my experience, have enough trouble understanding options and vesting as it is. Granting annual options that add on to the “tail” seems logical. I can see how confused people will be when management tries to explain the actual vesting of each grant and that they don’t all vest the same way. Even if the current granting cycle may not make as much sense, sometimes simpler is better, and I’ve found this is almost always true when it comes to compensation conversations.

    Second, it has the potential to become an administrative nightmare. A competent CFO (or your law firm) should be able to manage it properly and without issue. Having said that, I’ve seen a normal grant and vest process get screwed up (and started a company last year to address the problem that I’ve since shuttered) and I’m not optimistic there’s a clean way of administrating it without additional issues.

    So my concerns relate to (i) educating employees and communication and (ii) administration. Maybe I’m off base in my assessment.

    • I completely agree with the first – it’s confusing. I need to work to make it less confusing.

      I disagree with the second. It’s no more difficult to administer than any other grant.

      • Jeffrey Hartmann

        Personally I actually think it is quite clear, this is basically just a retention grant that will start vesting after your current options have vested but at the strike price of today. I think it makes things very simple for an employee to understand. However, maybe I’m just a weirdo and this stuff makes sense to me. We aren’t at the size we are granting options yet, but I’m thinking this could be a good way to manage things and will definitely keep this in mind when it becomes an issue for us.

        • Excellent. Yes. You grokked it.

  • Jay Batson

    A really interesting idea. This is why you’re such a great guy to have around; you’re always looking one step past the way people have done things forever – and what you see ahead makes sense.

  • This is exactly what is done with pre-IPO retention grants. No vesting in the first year or so, with vesting coming in later years when earlier grants are done vesting. I think it is a good idea, but the teams will still want the bonus shares.

    • Bonus shares are fine – it’s just a different conversation.

  • You’re right about the stacked scenario behaving like a “bonus” for a couple of years; that’s not necessarily the intent of a refresh grant, but not *that* big of a deal. Arguably any “bonus” senario that comes out of the situation in yrs 3 and 4 is a good dynamic anyway. A welcome freebie for everyone (refresh grants being relatively small amts as they are). Given the relative small size dynamic, you could argue the “bonus” years are actually part of the compensation :).

    Also seems like you’re optimizing for larger, more consistent, whole number vest counts in downstream years. Intuitively that seems fine, but a refresh grant isn’t about that. The value of the company, the option pool size, the diluted pool size, etc, are vastly different from when the person originally received their “big grant.” There shouldn’t be expectation that the whole numbers have much correlation between grant A and B after a couple of years. In fact, having them look that way, could actually add to confusion.

    In general it feels a little over optimized. That said, being clear that there is an alternative, come re-up time, and having that in the tool box for use, is extremely valuable. I can definitely see us using this in the future. There are scenarios in which it makes perfect sense, and philosiphically, one could indeed drive their entire refresh philosophy with it.

    Thanks for putting it down in black and white; very useful.

    • 1. I don’t agree that it’s a welcome freebie for everyone. Nothing should be a “freebie” – there’s only 100% of a company to give out so the ownership is being allocated from someone to someone else. If anyone – especially management – views it either as a freebie or an entitlement, that’s a problem. It’s also not necessarily small. I didn’t use percentages, but assume a 50% refresh over time on 20% ownership in a company. That’s a re-allocation of 10% of the ownership. That’s not a small number.

      2. Nope – I’m just using round numbers. The numbers could have been anything.

      I considered approaching this using dollar amounts instead of share amounts. That’s actually how I think about it – the current value that is being given out. For example, if I think a company is worth $50 million and we do grants of 1%, then I view the basis of the grant being $500k. When you shift from # of shares to actual dollars, you can start to calibrate around value being re-allocated.

      • re: your #1. when the numbers/%s are “big”… obviously the stacked dynamic “bonus” component gets “big” and therefore much more of a factor. my head wasn’t in a basis of 20% of the company when I made that comment. fundamentally, the points are the same, just saying that on the extremes, you may consider it differently. hearing your point though… if one agrees w/ the principle, it should be generically applied without bias; exceptions being exceptions.

        I personally hadn’t given this this much though until now.

        The dollar amount version of this post would be really interesting. I don’t think about the dollar part of this context… I think about the pie percentage part (which is an incomplete view).

        I did some charting the other day to try and represent the percentage visual expansion/contraction of “the pie” while also using dollar amounts for each stage of investments. You can do some interesting viewing of these dynamics using a multi-layer donut chart. You can see the entire current pie represented, as well as various rings and individual ownerships grow/shrink based on pool expansions… new investors… etc.

        • Jeffrey Hartmann

          I think you really should move to thinking about things as dollar amounts instead of percentages as soon as possible. Fred Wilson did an awesome class on skillshare about this, and he posted the video a few days back onto avc.com. I would check it out, it really is a good system to think about how you are rewarding employees. Here is the link to the video: http://www.avc.com/a_vc/2012/12/no-mba-mondays-this-week-or-next.html

  • I have a different approach. In my view option awards ought to be made based (almost) exclusively on the value a team member has *already* added. Awarding a big grant upon hiring and then mitigating risk by using long vesting periods has never felt right to me.

    Tacking on options that vest (favorable strike-price notwithstanding) in years 5 and 6 for a recent kick-ass job isn’t much of a reward, in my view, since the time horizon is so distant.

    If you believe in actually granting ownership as a reward, give ownership. Don’t handcuff those who are helping you realize your dreams for 5-6 years.

    Since our options are awarded for backward-looking performance, we vest 28% immediately, then 72% smoothly (no cliff) over the next 3 years. We don’t believe in awarding big chunks on the strength of a resume and a job interview. On the ground, we grant 2.5% of the company’s options each fiscal quarter. Each 2.5% block is granted to work / accomplishments in the prior quarter.

    Rather than having one giant grant plus subsequent bonuses and refreshes, we use lots of small ones.

    While this works for us at our very early-stage (less than 5 option-holders in our company at this point), I don’t have a clear line of sight as to how this would evolve as our ranks grow without swamping us administratively. So, that’s a potential weakness moving forward.

    This approach is a new experiment for me, but it’s the closest I can come to aligning interests.

  • I just heard on Twitter from @hunterwalk that this is how Google does it. “GOOG does this now – refreshers are 2yr grants (12 mth cliff, 1/24th mthly 2nd yr), w annual grants so always extending smoothly”

  • I agree with Adam. Getting options that far out isn’t really an immediate motivator, it’s more something to tie someone down for longer.

    It might not even accomplish that – if another company comes to the employee in question with an offer that includes equity, then the employee now has a choice between a 4 year hire grant vs a 2 year hire grant vs 2 year refresh grant. Assuming the companies are roughly similar enough that any of this matters in retention, the employee is better off by moving to the new company.

    • laurayecies

      We went through this last year with our refresh grants – the board
      insisted, against my recommendation, that the grants (which were
      meaningful) had a 2 year cliff and then 1/24th vest per month. It has a decidedly mixed result. Because this was seen as “non-standard” compared to what they perceive is going on in the industry a few employees were annoyed – felt that they were not being treated well and one mentioned it when he gave notice. The math makes sense in this process but the emotional side doesn’t necessarily compute.

      • Interesting. Do you feel like the goal was clearly expressed to the employees?

  • John Hinnegan

    Longer vesting periods favor existing shareholders (ahem, invested VCs) at the expense of the employee. Not saying that was part of your motivation when you suggested this kind of scheme, but you’ve got to recognize how it’s going to come across.

    • And founders. And all the employees that have been there longer. I don’t think there’s real misalignment.

      • John Hinnegan

        So then why not just advocate giving employees less on the same vesting schedule? Or are you saying to give them more options further out than you would nearer in time? Thinking about this from an employees perspective, I think 4 years is a pretty long horizon already, particularly for a startup. Your suggestion makes more sense for bigger companies, but then you get in the situation of “It’s year 3, and I’m making the same money I would have doing a great job as I would have if I had done the bare minimum not to get fired”.

        • Recognize that in a success case, the value of the options increase (given the lower strike price) so you want them vesting out in the future for a while. Four years is a pretty standard vesting period for a startup (or any private company) so if I’ve got future value “vesting” and the future value increasing as the value of the company increases, that’s a powerful retention mechanism.

          I’m not sure I understand your year 3 reaction / quote.

  • I completely agree. The key to making this a reality are the two points mentioned in the comment above. One way to do this is by splitting the bonus options and refresh options.

    The bonus options are part of the bonus plan and should be stacked. Meaning you performed better than we expected when we gave you your original options so we are adding some more. Just like a cash bonus. This should be done as part of the annual review.

    The refresh options are to retain and incentivize key employees so they stay committed to the long-term success of the company. Adding these options to the tail end of the existing vesting period serves to keep these employees aligned with the continued success of the company beyond year 4. However these can be distributed independently of the annual review. Either on the anniversary of the start date for each employee or mid-way through the year for the entire company.

  • Some visuals would help explain this… and the dynamics of options in general. hmmm…

  • Egad! Someone finally thinking clearly. Thank you for exposing it with the simple language we appreciated in Venture Deals!

    I think the complexity of stock option grants has confused people long enough. The way the system is structured today, long-time loyal employees are essentially given a disincentive for staying. If they have reason to consider leaving (like that hot new startup idea), good employees should be tempted by options left on the table. That’s how it should be.

  • From a CEO friend at a Bay Area firm. “About half of the recipient of these delayed vest grants were simply pissed
    The basic problem is that it was seen as non-standard and “unbalanced” company/employee
    Not everyone on the team was as upset – some people just don’t pay a lot of attention to the details but the savvy ones do
    My XXXXX just left. He is a former corporate lawyer so he was not happy with the grant – ironically we might have been better off not doing a refresh for him as he got a very good grant when he started – it just was annoying
    Problem is it’s just not the norm – people compare it to grants their friends are getting at other companies”

    • I have a feeling I’ve recently had a conversation with that same friend.

  • Mark Skaggs

    It might make sense from a logical or mathematical standpoint but if the options are described as a reward for your work, it’s not pleasant to wait 3 years in hopes of reaping benefits from excellent work you’ve just delivered. Many things can and do happen over 3 years making it possible your “reward” will be worth less or worthless.

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