Start-up insights: Share options – a reprise: vesting and other issues

We have previously run through some of the principles involved in negotiating vesting provisions for founder shares and employee share options.

Share Options: Two young businessman having a successful meeting at restaurant.

In this post, we’re looking at some of the more detailed choices facing management and investors, about vesting and some broader issues, as they shape an attractive but workable option scheme for their key employees.

Drafting a fair set of share option vesting provisions raises the same principles as those that arise in drafting leaver clauses for founders. In both cases, in essence, the question is – do key employees get to earn (or keep) shares in the business when they leave the company?

There are nuances and differences, however, regarding custom and practice, taxation, and mechanism, which we bring out in this post along with a couple of other option-related points.

As ever, heed the wealth-warning: these posts are musings, not tax or legal advice, for which there are many fine accountants and lawyers.

What do vesting provisions aim to achieve?

SaaSco needs to attract and retain the finest talent. There’s a good chance it’s running on a very tight budget. Key hires – lead developers, experienced marketing staff and so on – are expensive. So how to balance these conflicting dynamics? Well, options can help balance the scales (but, that said, see below for some thoughts on how widely spread an option scheme should ideally be).

The Company wants to preserve cash whilst issuing not too many options, and in return getting and retaining quality people, and not just getting them, but getting the best out of them. Options can help achieve these objectives in a few ways:

  • Most obviously, they have a potential financial value that, albeit speculative, is a deferred salary, helping attract more senior talent than is possible just using SaaSco’s limited cash reserves;
  • The value of the options is generated through collaboration: everyone gets rich together or not at all. In the right hands, thoughtfully-structured options drive good corporate behaviour;
  • More diffusely, the shared ownership of the company may even generate a sense of team or family, transcending the simple maths of the option’s valuation (as this goes to emotions, I rely on the opinions of other sage observers. I had my empathy circuits removed as part of Chartered Accountancy training some decades ago); and
  • Assuming that the fuzzy family stuff doesn’t help, the fact that options have to be earned over time creates financial incentives and sanctions that encourage staff not to leave.

The first three features of an option scheme – delivering value to the employee, while creating a joint enterprise, and a sense of family – need to be tempered by the fourth factor: these options need to be earned, and their value retained. That’s where vesting comes in.

What is vesting – and how does it work?

Vesting refers to conditions being met allowing options that have already been issued to be exercised, allowing the holder to subscribe for actual shares.

The usual employee-specific conditions to vesting are:

  • Time-served; and / or
  • Performance conditions.

As examples, these might be drafted as: The employee is entitled to subscribe for a total of 1,000 new ordinary shares in SaaSco at a price of £x per share, at the rate of 200 shares:

  • for each completed year of service with SaaSco;

and / or

  • for each year in the first five years of service in which the employee meets their agreed sales targets.

Once these conditions, or combination of conditions, are met then the shares are vested. That doesn’t necessarily mean that the employee owns the shares – in fact, usually the opposite at that stage – but that the employee has have earned the right to exercise the option, by paying up the agreed subscription monies, thus receiving the actual shares.

The employer may, however, impose additional employee-specific or even general conditions to vesting. For example, SaaSco might set the following hurdles:

  • the founders may not like the idea of having many small shareholders, each needing to be consulted on corporate actions, and each with an actual vote (a dangerous thing, democracy). So they might stipulate that options can only be exercised on an exit or IPO, or after a long-stop date of several years;
  • equally, the founders may hate the idea of employees leaving, maybe joining a competitor, and owning some shares, so the options cease to be exercisable or are simply cancelled in the event that the employee leaves SaaSco.

Choosing the right vesting conditions is an art not a science. We tend to favour time vesting for most staff as most roles change over time (especially in start-ups) and success usually doesn’t translate into a measurable objective for that one employee. Sales and marketing staff are the one typical exception to the rule. Time vesting is to some degree based on performance as – brutally – if the employee doesn’t perform then they won’t be around for long.

As, contractually, the option agreement is open for negotiation, the founders (more so than the employees, in practice) can paint on a blank canvas. That said, the conditions to option-vesting need to be fair. To illustrate, combining some of the above conditions might result in the following proposition to employees:

  • here are some options to buy shares at an agreed and favourable price. If you miss targets in some years then you lose that proportion of the options. If you subsequently leave, then you lose your options anyway – even if you had already hit your targets. Even if you hit targets and stay with us forever, you can only exercise the options if we sell or IPO.

Hmmm, thinks the employee. I may be prepared to take a chance on one or two of these conditions, but what’s the chance of all three sets of traffic lights being on green? Does this really make up for late nights, uncertain futures, and lower salaries?

Occasionally options contain provisions for time-vesting provisions as well as forfeiture on leaving – which is contradictory, at the least.

At DSW Ventures, our approach is to advise management to make the conditions both fair and achievable, taken as a whole – and to happily accept that after years of achievement and salary-sacrifice, an employee might leave and take options or actual shares with them. Of course, with a real interest in the equity of SaaSco, we would be much more hopeful that staff would in any case prefer to stay.

A cynical management team might take the view that mid-level employees won’t read or perhaps understand the terms of their option awards. Even if we could endorse that view, the employer risks killing employee morale when (and probably when, not if) the staff as a whole realise that their options are full of holes.

Early vesting

In the UK, options that aren’t yet vested – maybe two years into a five year vesting schedule – will typically vest early and entirely on a sale or IPO of the company. It’s not mandatory, just custom and practice.

In contrast, US practice for what they call accelerated vesting is more rare. In the case of an early exit of a US venture-stage company, employee option-holders may have to wait for their personal conditions to be met, at which point the acquirer mops up the resulting shares at the original offer price.

There are a few pros and cons of each approach. Early vesting has disadvantages:

  • under the UK approach, late-joiners may do just as well as time-served employees, which is unfair. Hopefully everyone is happy enough, and to the extent that some staff feel unhappy, well, that’s the acquirer’s problem; and
  • on which point, a UK acquirer will need to put in place remuneration schemes to hold on to key staff whose option scheme has just paid-out in full. Maybe that’s going to cost a few percentage points of the acquisition price. The UK acquirer, if they are smart, will therefore reduce the price offered to founders and VCs. So the generosity of allowing early option vesting isn’t without cost to SaaSco’s existing shareholders.

On the plus side, early vesting has positives too:

  • early vesting encourages staff to welcome an exit, even if their options aren’t yet fully vested. Any acquisition is a threat to employees (are these guys tyrants, will I keep my job, are they solvent?) but if key staff get a big pay-day, then they are less likely to drag their feet; and
  • employees have more certainty about what they are committing to. They may have been happy about committing to work five years for cute little SaaSco, but having to stay on for the final two years as tech-giant minions – really?

On balance, our views favour the UK approach – unsurprisingly.

Whilst on this subject (ok, very much off-topic, but we have a bee in our bonnet about the whole issue): share-based payments are a big cost for venture-stage companies and increasingly for larger corporations too. That’s why we insist on factoring in the cost of an option pool in negotiating the pricing for a VC deal. But the pool needs constantly replenishing – albeit with a smaller proportion of the equity, as SaaSco grows up and becomes a top-100 employer. Venture-stage companies don’t formally account for this cost through their profit and loss accounts – it’s impractical – although if they did, many would be hideously unprofitable. I guess the argument is that you only have to give away 20% of the equity to employees at the start-up stage: at scale, the economics right themselves. Large corporations are a different case. They may be growing but their economics will have reached a quietly evolving equilibrium. So giving away equity to subsidise the wage bill needs recognising as a cost. Amazingly, lots of quoted company management and analysts seem to think this is a “cost of the market” and not a real charge to the company. They add it back in adjusted EBITDA. For any readers who are regular stock market investors, beware. This article in the FT splendidly makes the point. 

Cliff-edge vesting

Some options specify cliff-edge vesting conditions. These might be time-based: options vest after five years in total, or not at all. Or, they vest on achievement of sales targets, or not at all.

Plenty of companies do this, and the argument in favour is that it maximizes the incentive to achieve.

DSW Ventures subscribes to the counter-view, which is that employees will see too many extraneous reasons that would cause them to fall short (pandemics, maybe) so why try hard in the first place? The other benefit of graduated schemes is to give a second chance. We might target £1m per annum of new sales but, know what? £950k isn’t too shabby.

Why not just issue shares?

There’s a certain price and comfort in owning an actual share. SaaSco’s not paying dividends so it’s not like the employee is losing income. They probably have rights over a tiny fraction of the equity, so they are hardly losing out on a say in the company’s management. It’s just that it’s real – a thing, not a right to own a thing. I would rather be a shareholder than have options.

So why not issue shares and be done with it? OK, fair question, but consider the following:

  • if you want to replicate the economics of the vesting conditions, SaaSco’s Article of Association will need to be redrafted with pages and pages of employee-specific leaver-clauses to claw the shares back from leavers and employees who fail to hit performance conditions;
  • it’s painful to buy in shares. Better not to have issued them in the first place;
  • shareholders have rights – pre-emption, to be given notice of general meetings, that sort of thing – and have a tendency to do their own thing when the lawyers need them to sign a document. From an admin point of view, the fewer actual shareholders the better;
  • issuing shares at a nominal value may well create a tax liability at that time. The tax liability even for non-tax-approved option schemes tend to be kicked well down the road.

That said, for a key employee being bolted-on at an early stage, that sense of ownership may help them transform into a late-joining fonder, so it is worth serious debate about issuing actual shares.

Comparing vesting conditions with founders’ leaver clauses

The drivers and economics of vesting conditions and leaver’s clauses are very similar. There are nuances – founders leaving is an existential threat, so timelines might be longer – but the principles are the same and the respective schedules may look fairly similar.

One pitfall to avoid is accidentally making exercised options subject to leaver provisions. Having vested the options and subscribed for shares, the poor employee sees their shares at jeopardy once again. Not a great incentive scheme, all-in-all.

Who should get options?

A vesting-related issue is the extent to which options are shared among the employees generally. The point is that vesting conditions are there to create motivation. But what if the recipient doesn’t care one way or the other? Should they be awarded options in the first place?

Obviously not. But how to tell who really cares?

Some companies use staff consultation to determine the employee’s priorities – cash, benefits, pension and so on – to determine how each component (including options) fits into the employee’s hierarchy of needs. Company-specific views will vary, but the general feedback from consultations and anecdotally seems to be –  as one might intuit – that options are more valued by the most senior staff.

The questions to ask about each individual candidate for an options award are:

  • do they really get what options are about (if not, how can they value and be motivated by them)?
  • are they at a level where they can understand SaaSco’s prospects and anticipate how genuinely real the eventual pay-day might be?
  • is their role one that is likely to last the duration rather than one that churns constantly?
  • is this employee earning enough to be bothered about anything but meeting this month’s rent?

If the answer to each question is clearly yes, then an option-award makes sense.

Occasionally founders wonder about whether a widely-spread award of options would help create a sense of family. Our challenge is whether an entry-level staff member is imbued with a warm sense of being a member of a team if they receive a piece of paper that they simply do not understand or value. And for those that cite the John Lewis partnership approach, it’s worth remembering that John Lewis rewards its partners not with shares, but with cash, each year.

Pricing and valuations

Pricing and valuations are two separate issues, connected by tax considerations.

Exercise pricing

The exercise price of an option is how much the employee needs to pay to subscribe for each share when they exercise the option. This matters. When SaaSco sells-out, the price paid for the equity will vary depending whether the employees turn up to the completion meeting with £1m, or just 10p, to subscribe for their share of the company.

It’s up to company and employee to agree the exercise price and, yet again, there are two schools of thought:

  • keep the employees hungry: set the price at or around the market-value (maybe last-round price) so there is no day-one in-built value in the options. Only by increasing the value of the company and its shares do the options accrue any value. In this way, not only do all the vesting conditions need to be met but in addition the company has to grow in value.
  • Give the employees a flying-start: set the price as low as possible (nominal value, maybe?) so they have more certainty of that pay-day and have more motivation to work smart and stay loyal. This approach makes most sense if the inbuilt value is clearly communicated to the employees during the negotiation and option-awards although, too often, pricing is overlooked in the process.

DSW Ventures favour the latter approach. Partly, that is because that approach seems to work best in incentivising staff at not a huge cost. Mainly, though, we’re just lovely people.

Valuations

Ok, so contractually company and staff can agree any exercise price they like at or above nominal value. Wonderful, but – employers giving valuable consideration to employees at a big discount is a matter of interest to HMRC. So the valuation can matter, particularly if it is more than the agreed exercise price.

We aren’t going to cover the whole tax options tax regime, or revisit company valuations methodology. We just want to note that, in situations where valuations are relevant to an options award (such as in an EMI scheme), there is considerable scope for agreeing a valuation with HMRC that puts employee shares in-the-money versus the headline valuations from the last round price. Here are some thoughts about why the ordinary shares held under option by SaaSco’s full-stack developer, representing 0.5% of its equity, are worth less per share than VC’s 25% held in B preferred shares:

  • the market pays more per share for big chunks of equity compared to uninfluential minorities as they are more likely to buy a ticket to the high table;
  • VC’s B preferred shares come with a bunch of rights that are in addition to their power as a big shareholder – vetoes, rights to management information and so on. It makes sense that these have got some commercial value, which ordinary shares lack;
  • the economic rights of the two classes are usually different. Ordinary shares are likely to lack rights such as preference (which may provide for VC to get their subscription monies back plus a share of the remainder on exit) or possibly a special dividend entitlement;
  • VC’s shares may well be transferable, whereas employee shares almost always are not. The right to get out of an investment is worth as much as the right to buy in the first place.

So, in trying to create an option scheme that truly incentives staff, don’t forget the exercise pricing issue, and press hard to get a fair valuation with HMRC.

Documentation and structure

The documentation and mechanisms constituting employee share option schemes vary in rigour and in structure.

At its simplest, an employee share option is constituted by an agreement between company and employee: “do x and you can buy y shares on the cheap”. This might be just a clause in the employee’s service contract, or even verbal (which is bad, see below).

A more complex (and expensive and cumbersome) scheme might be an Enterprise Management Incentives (EMI) scheme, including a set of general scheme rules, a HMRC-approved share valuation, and option-award letters, in addition to any agreement in the employee’s service agreements. Even more complex might be a scheme involving an Employee Benefit Trust, although these tend to have specific uses, and have been tarnished through their use in aggressive tax-planning.

The differences tend to be about:

  • tax advantages (especially of EMI schemes); and
  • a more formal structure such as the EMI scheme will probably cover off all the details – such as vesting – that a simple option award in a service contract, or an email after an employee’s annual review – may not have covered. Good fences make good neighbours. Agreeing the details avoids subsequent disappointment and argument.

The disadvantage of more formal option arrangements tends to be cost and time.

As a compromise, rather than spending thousands on legal fees for each start-up, not all of whom succeed, at DSW Ventures we advise management to document the key commercial points in a short-form option award (or at the very least in the service contract) with a view to formalising the agreements within an EMI scheme once there is more at stake and more money for legal fees.

There is a downside to this approach, which is that success over time will increase the valuation that can be agreed with HMRC although, as discussed below, this may be mitigated by choosing the right time (a slump, say) and methodology.

Choices, choices.

Do it right

As noted above, we favour getting the bare bones of the option awards documented, but perhaps deferring the whole EMI scheme until SaaSco has made a little progress. That said, make sure that those bare bones are documented – even if only in the service agreement – and cover numbers, conditions, and pricing. The lawyers can pretty up the documentation in good time.

Verbal agreements aren’t worth the paper they are written on. A friend worked many years for a start-up that successfully exited to Microsoft. During those years, the founder had made many promises of options. My friend pointed this out with Microsoft’s in-house legal team. In fairness, they did offer a cash compensation figure, but well shy of the value of the promised option values. My friend wisely chalked the incident up to experience and banked the cheque. This isn’t just a concern for employees – if options are to work as a proper incentive scheme, everyone needs to clearly understand their terms. And if a bunch of promises about options surfaces in due diligence during a sale, it becomes an obstacle to a clean exit.

One final, seemingly trivial note on the same theme. Never, ever, specify an option award (or any instrument like a convertible or ASA) as a percentage. One per cent of little SaaSco is not the same as one per cent of unicorn SaaSco. Essentially the option becomes non-diluting, increasingly valuable to the employee, and an increasing blackhole for the employer.

Round-up

Share option schemes are an essential part of incentivising and retaining a winning team. But they cost a lot in dilution. So, make sure that they work – vesting conditions and exercise pricing that are relevant to each employee, and are fair in overall terms – and make sure that the workings and above all the value of the options are communicated to the employees. Otherwise, the company bears all the cost and gets a fraction of the benefit.

David Smith 

Partner, DSW Ventures