Friday, September 29, 2006

Stock Options: The Myth of the 4-Year Vest

Fall is the time for term sheets to be issued and compensation committees to meet here in Toronto, and once again I ask: why do VCs continue to design stock option plans that contain a 4-year vesting schedule?

Stock option grants are made to attract and retain the best talent for a startup at a specific phase of growth. During the internet boom, employee churn was high and liquidity came fast often before a company had recurring revenue. Back then, it made sense to design a plan around a 4 -year period, which was roughly proximate to the time a company would go from formation to IPO.

Applying the same strategy to today's market makes as much sense as applying fake tan before exfoliating: either way, things don't look natural and you get uneven results. Without an irrational stock market to take companies out early, it is inevitable that companies will go through employee and executive churn. In fact, it's desireable. The hard charging Series A CEO who can manage many roles as the company grows is not likely to be a good fit for the company as it matures. Why create an artificial incentive for him to hold on to his job after his time?

Stock options should incent employees to deliver value during the phase that they are most valuable to the company. I understand why an investor would wish to pursue what is an outdated strategy; it creates a nice hedge against investor dilution by betting employees will churn before they vest. But why is a 4-year vest in the best interests of the company?

For those VCs who insist a 4-year vest is consistent with the market, I invite them to pay closer attention to the high tech companies in the US public markets. Thanks to changes in the IRS treatment of change of control payments made to employees, more and more companies are shortening the vesting periods - and making upfront vested grants- to the major option plan participants.

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