Thursday, November 09, 2006

Series A: The Size of the Employee Stock Option Plan

A lot of my work includes compensation - sales incentive plans, executive compensation plans and stock option plan design. So I tend to be a bit of a theory wonk when it comes to compensation strategy. Which is why I find the consistently applied top of ESOP to 15 -20% of total capital such a weird feature of a Series A (or B) round of investment.

Incentive compensation should, in theory, vary from startup to startup depending on the key drivers of growth for each. To determine the apporpriate size of the stock option pool, traditional compensation theory would demand that a company:
  • take eligible headcount projections for the next 3-4 years of the business;
  • calculate the range of annual option award that may be awarded as a bonus to each eligible plan participant;
  • discount that total figure for notional attrition of employees;
  • assume that the company will follow a strategy of granting more options upfront to employees at time of hire; and
  • calculate an adequate reserve for attracting and retaining an IPO-calibre management team.

The headcount can vary widely between, say, a diagnostics or therapeutics startup, (where there is only incremental headcount growth until a major patent license deal is struck or until clinical trails are complete) and a software startup (where headcount must be added for product support, sales and channel development). So why the consistent result?

There are other variables which also should make the amount of top up vary widely. For example, some of the protective structures for management that were adopted to counter the harsh effects of down rounds post 2000 (options with anti-dilution mechanisms, IPO bonus pools) should perhaps lead to a higher top up than the rule of thumb 15-20% in order to attract and retain employees.

And let's not forget the impact of participating preferred shares, which provide holders with a liquidation preference ahead of the common shareholders. In the current M&A environment, where acquisition multiples for some software sectors – e.g., security - are low, liquidation preferences can erase much of the value of common shares, in turn reducing the value of common share options as an employee retention tool. Perhaps even worse, some commentators have pointed out that they can incent management to focus on "bet the farm" strategies and opportunities, even when market conditions do not warrant it. Surely, one might think, this would lead a comp committee or an investor to reserve a higher than usual option pool?

It is essential that VC investors do what is reasonably necessary to secure key employees during those phases of a company's growth when those employees are most vital. For many cases, the 15 -20% rule of thumb may not do the job.

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