Startups are Granting Share Options Wrongly.
Worry later about the valuation of employee share options.
It has become an almost universal practice for startups to issue stock options ("options") to employees. The reasons are logical: i) conserve precious cash for operations, ii) align interests and retain employees, iii) encourage long-term thinking. It is therefore not uncommon for employees to have a far bigger proportion of their total comp in the form of options.
We also do know that most start-ups fail. When this happens, employees are left holding the can because of the opportunity cost of forgoing a higher salary, effort wasted and options becoming worthless.
Are options then still the best way to attract and retain talent in startups ? It can be but it is time for a re-think of how we can do it.
First - the traditional method of granting options:
a) 15% of Company reserved for Employees
a) 1 year cliff
b) 4 year vesting
c) Exercise price = fair valuation of Company at grant
Most of our start-ups we had worked with had largely this options scheme. Let me share with you why this aint going to work out....
It is still not worth it for employees.
Let's see why startups fail ...
It is clear that NONE of the 20 reasons of why startups fail is related to how startups grant employee stock options.
Start-up founders often feel that just because they started the company, they are entitled to the lion's share of the upside. As a result, they become overly protective of their stake in the company. This spills over to how they start to count pennies when they issue options to employees - forgetting the risks and opportunity costs that the employees have to bear. Dilution becomes a dirty word.
Jack Ma of Alibaba said, "Put the Customers First, Employees Second, and Shareholders Third". He is right. Because every successful company has happy customers and employees. This will ultimately benefit shareholders.
For start-ups, are we bold enough to try a different way :
a) 30% - 40% of shares reserved for employees (instead of 15%)
b) 1 year cliff and 8 year vesting
c) Exercise Price - 20% - 50% lower than current valuation
d) Tie options grant to revenue, customer acquisition milestones
Ultimately, the founders will own significantly less of the Company but 5% of a $1bn company is still better than 50% of a Company that goes bust.