Employee Equity: Options

A stock option is a security which gives the holder the right to purchase stock (usually common stock) at a set price (called the strike price) for a fixed period of time. Stock options are the most common form of employee equity and are used as part of employee compensation packages in most technology startups.

If you are a founder, you are most likely going to use stock options to attract and retain your employees. If you are joining a startup, you are most likely going to receive stock options as part of your compensation. This post is an attempt to explain how options work and make them a bit easier to understand.

Stock has a value. Last week we talked about how the value is usually zero at the start of a company and how the value appreciates over the life of the company. If your company is giving out stock as part of the compensation plan, you’d be delivering something of value to your employees and they would have to pay taxes on it just like they pay taxes on the cash compensation you pay them. Let’s run through an example to make this clear. Let’s say that the common stock in your company is worth $1/share. And let’s say you give 10,000 shares to every software engineer you hire. Then each software engineer would be getting $10,000 of compensation and they would have to pay taxes on it. But if this is stock in an early stage company, the stock is not liquid, it can’t be sold right now. So your employees are getting something they can’t turn into cash right away but they have to pay roughly $4,000 in taxes as a result of getting it. That’s not good and that’s why options are the preferred compensation method.

If your common stock is worth $1/share and you issue someone an option to purchase your common stock with a strike price of $1/share, then at that very moment in time, that option has no exercise value. It is “at the money” as they say on Wall Street. The tax laws are written in the US to provide that if an employee gets an “at the money” option as part of their compensation, they do not have to pay taxes on it. The laws have gotten stricter in recent years and now most companies do something called a 409a valuation of their common stock to insure that the stock options are being struck at fair market value. I will do a separate post on 409a valuations because this is a big and important issue. But for now, I think it is best to simply say that companies issue options “at the money” to avoid generating income to their employees that would require them to pay taxes on the grant.

Those of you who understand option theory and even those of you who understand probabilities surely realize that an “at the money” option actually has real value. There is a very big business on Wall Street valuing these options and trading them. If you go look at the prices of publicly traded options, you will see that “at the money” options have value. And the longer the option term, the more value they have. That is because there is a chance that the stock will appreciate and the option will become “in the money”. But if the stock does not appreciate, and most importantly if the stock goes down, the option holder does not lose money. The higher the chance that the option becomes “in the money”, the more valuable the option becomes. I am not going to get into the math and science of option theory, but it is important to understand that “at the money” options are actually worth something, and that they can be very valuable if the holding period is long.

Most stock options in startups have a long holding period. It can be five years and it often can be ten years. So if you join a startup and get a five year option to purchase 10,000 shares of common stock at $1/share, you are getting something of value. But you do not have to pay taxes on it as long as the strike price of $1/share is “fair market value” at the time you get the option grant. That explains why options are a great way to compensate employees. You issue them something of value and they don’t have to pay taxes on it at the time of issuance.

I’m going to talk about two more things and then end this post. Those two things are vesting and exercise. I will address more issues that impact options in future posts in this series.

Stock options are both an attraction and a retention tool. The retention happens via a technique called “vesting”. Vesting usually happens over a four year term, but some companies do use three year vesting. The way vesting works is your options don’t belong to you in their entirety until you have vested into them. Let’s look at that 10,000 share grant. If it were to vest over four years, you would take ownership of the option at the rate of 2,500 shares per year. Many companies “cliff vest” the first year meaning you don’t vest into any shares until your first anniversary. After that most companies vest monthly. The nice thing about vesting is that you get the full grant struck at the fair market value when you join and even if that value goes up a lot during your vesting period, you still get that initial strike price. Vesting is much better than doing an annual grant every year which would have to be struck at the fair market value at the time of grant.

Exercising an option is when you actually pay the strike price and acquire the underlying common stock. In our example, you would pay $10,000 and acquire 10,000 shares of common stock. Obviously this is a big step and you don’t want to do it lightly. There are two common times when you would likely exercise. The first is when you are preparing to sell the underlying common stock, mostly likely in connection with a sale of the company or some sort of liquidity event like a secondary sale opportunity or a public offering. You might also exercise to start the clock ticking on long term capital gains treatment. The second is when you leave the company. Most companies require their employees to exercise their options within a short period after they leave the company. Exercising options has a number of tax consequences. I will address them in a future blog post. Be careful when you exercise options and get tax advice if the value of your options is significant.

That's it for now. Employee equity is a complicated subject and I am now realizing I may end up doing a couple months worth of MBA Mondays on this topic. And options are just a part of this topic and they are equally complicated. I'll be back next Monday with more on these topics.

#MBA Mondays

Comments (Archived):

  1. Larry crume

    so how much is typically given to the founders, directors,engineers, etc?

  2. Bob

    These Monday posts are terrific. You might want to talk about qualified vs. non-qualified stock options in a future segment. Thanks, Fred.

  3. derekvaz

    Fred, great post! Can you (or have you already?) discussed the effect of dilution on stocks and options? Especially for start-ups who take funding (or are considering it), this would be an interesting topic for the blog.

    1. derekvaz

      Ah, never mind — here it is. http://www.avc.com/a_vc/201…I’ll be sure to get coffee before commenting next time.

  4. Eric Leebow

    Interesting post. What if the employee leaves quickly, should they still be granted options. You could have someone jumping from startups, just looking for the next place they can find a minimum stock options or be part of something. It’s interesting to think how a company like Zappos would pay people to leave, which rarely someone will take up this offer.

    1. jv

      As Fred outlined, most agreements have a “vesting cliff” – in which no options are awarded during the first year. If someone leaves before the cliff, the get nothing.

  5. jv

    How about a post on Stock Options vs Restricted Stock Grant via Reverse Purchase Agreement ? It’s been my observance that folks tend to use a Restricted Stock until a Series A is completed – this way the founders + early employees can pay off a low valuation and get have any stock-related rights – and then do Options out of the Series-Defined equity pool thereafter.

  6. Marc Summe

    Fred, thanks for writing on this topic. There is very little information about this topic on the web. I joined a start-up about a year ago and didn’t fully understand what I was receiving in terms of options. Im motivated by equity and in hindsight I should have negotiated for more equity when I started. I just heard the number of options and thought it sounded like a lot. Shame on me for not learning more before starting. I think that might happens a lot though with early stage junior hires, like me. Live and learn.

  7. awaldstein

    Important, ageless discussion.Every founder and exec at a startup needs to explain as they recruit the value of the options. Invariably this is complicated and misunderstood as valuation is so difficult to articulate to a normal employee.Does anyone have a good answer to the question of what is an option grant really worth? Some simple math?

    1. JLM

      Black Scholes formula which though complicated is a plug and play formula which can be modeled using assumed criteria. It is complicated to do by hand but it is easy as pie to use a calculator.

      1. awaldstein

        Thanks JLM. I’ll check it out.

        1. Kyle Pearson

          Here’s a link to the calculator in simple form. I’m not sure how you would use it in a start up scenario because you need to estimate volatility, which involves the std dev of the stock price and percent changes? good luck anyways http://www.money-zine.com/C

          1. awaldstein


          2. JLM

            Use a range of volatility rates — I think the volatility estimate is the soft center of BScholes — and graph the resulting values.Then take a dart — literally — and land somewhere inside that range — the width of the chalkstripe.You have to make some decisions which require judgement.As long as you are methodical, you cannot be criticized for your assumptions.The answer reflects the difficulty of the assignment.What the hell is anything worth when it does not trade?

          3. Pat

            Black-Scholes is meaningless. There is no market for startup options. Startup options are subject to dilution in a way the NYSE options are not.

          4. Kyle Pearson

            Thats what i was saying. no market = no prices or measurable deviations. Didn’t think about the dilution part tho. thx

          5. fredwilson

            wordand yet we are forced to use it by our auditorssometimes i want to shoot myself and them 🙂

    2. David Semeria

      Arnold, this a huge simplification, but there are basically two ways of valuing options: the easy way and hard way.With the easy way you just take the market price and subtract your strike price. So if you have a million options with a $1 strike on a $2 stock you’re sitting on million buckaroos.The hard way leads to a higher valuation but involves some really tricky maths. You basically take the answer from above ($1 per option) and add a further component based on the stock volatility and how far out the strike date is.The more volatile the stock (somewhat perversely) and the longer the duration, the more your option will be worth.

      1. awaldstein

        much thanks david

      2. Pat

        This is meaningless. There is no market for startups options. ( Exception being the Facebooks of the world).Mechanisms to price stock market based options are not applicable for startup options because: * VC liquidation preferences * dilution by later rounds of funding * real possibility of the startup going out of business * startup options are not liquid * option pricing is determined arbitrarily ( the price has to be in a band that the IRS is comfortable with but this is not the same as a true market pricing )

        1. David Semeria

          I was explaining how options are priced in general terms.Absent market inputs for many variables, it is still possible to make a decent estimate.The largest component for an early-stage startup will always be the time value. When you combine a far off expiry with (by definition) high volatility – you will always get a big number.

      3. ShanaC

        The more volatile the stock (somewhat perversely) and the longer the duration, the more your option will be worth.Wouldn’t the value therefore be coming from the long term movement of the option in comparison to the stock? Would it therefore make sense to hedge against options in general because direction is unpredictable (options move regularly, but we don’t know the direction, hence why VC is risky?)

        1. David Semeria

          When considering options and futures, the more volatile the underlying instrument (in our case a share in a company) then the more valuable the options will be. This is somewhat perverse because volatility can work both ways (ie a highly rated stock can also depreciate a great deal) – but that’s just the way it works.The only feasible way to hedge against a fall in the value of your options is to try and sell some underlying stock – but this is frequently hard, and possibly illegal – especially if the options have not vested.

          1. ShanaC

            I’m assuming for a publicly traded stock this is not the case? (the illegalpart, the options part. I could buy options/sell option and do the samewith the stock)

          2. David Semeria

            Options are usually the hedge, not what you hedge against.For example, if you’re a long-term owner of a publicly traded stock and you think it’s in for a short-term decline, you can lock into your gains by either buying a put or selling a call.If you’re really interested in all this stuff you should talk to Dave Pinsen – he’s the expert.

          3. ShanaC

            🙂 will do.

          4. Dave Pinsen

            I wouldn’t say I’m an expert, but what David writes above is correct. If you want to get a better feel for how put options can be used to hedge a stock position, you might want to take a look at the free trial version of Portfolio Armor available in Seeking Alpha’s new Investing Apps store (you need to be registered with Seeking Alpha to use it, but that’s free too). Pick a stock you’re interested in, and then use the app to find out the optimal put option to hedge that stock against a certain decline in value (e.g., against a greater-than-20% drop). Then save the put option and the underlying stock to a Yahoo! Finance portfolio and see how they move in relation to each other. All things equal, as David said, higher volatility will increase the value of your put option, and lower volatility will decrease its value; also, the value of the put option will also tend to move inversely with the underlying stock. In addition, as the put option gets closer to expiration, ‘time decay’ will start to kick in and decrease the value of the option as well. Probably easier to get a feel for this by watching an example or two.

          5. David Semeria

            Good stuff, Dave.One thing I’ve never understood is why no directional bias is applied to volatility.A stock with 30% volatility composed mainly of upticks should in my view have a higher ‘normalized’ volatility than one with a 50% vol composed equally of upticks and downticks.Obviously, this applies to calls – the opposite would be true of puts.

          6. Dave Pinsen

            See my response to Shana below, but your explanation was tough to improve upon.

      4. fredwilson

        this is the math and science of options that i did not want to get into in the posti love that you are getting into it in the comments!

  8. Eric Leebow

    Yes, good find with the “vesting cliff,” yet should it be about time or about what work can be done. I’ve spent a year with a developer before, and they did nothing beneficial. I think what’s more important than time is results. Some sites give out founders awards, such as Google.

  9. DaveR

    Founders typically start with 100% and start diluting themselves to attract talent, outside financing, etc. In some situations an infusion of capital or IP at the onset of a venture might have founders start with less than 100%, but it’s effectively the same thing as founders starting with 100% and using equity and perhaps other vehicles (e.g. revenue sharing for an IP acquisition) to acquire resources instead of ready cash.Equity compensation for different participants is highly variable based on the prospects of the venture, and other compensation vehicles being used (cash, benefits, etc.), however, as ventures mature and the trajectory becomes more clear equity participation becomes relatively consistent.

  10. DaveR

    Founders typically start with 100% and start diluting themselves to attract talent, outside financing, etc. In some situations an infusion of capital or IP at the onset of a venture might have founders start with less than 100%, but it’s effectively the same thing as founders starting with 100% and using equity and perhaps other vehicles (e.g. revenue sharing for an IP acquisition) to acquire resources instead of ready cash.Equity compensation for different participants is highly variable based on the prospects of the venture, and other compensation vehicles being used (cash, benefits, etc.), however, as ventures mature and the trajectory becomes more clear equity participation becomes relatively consistent.

  11. Manshu

    Thank you for doing this great series. I look forward to your post every Monday. Thanks!

  12. DaveR

    There are situations in which founders should be granted options. For instance, I was considered a co-founder and VP Sales/Marketing. After some significantly dilutive events the BOD moved me into the CEO role and added ISOs.Another topic for discussion: what portion of “founders shares” do investors typically require founders to put into a vesting schedule to promote retaining founders and promote shared objectives?

  13. David Haber

    Thanks for the great post!I know you have touched a bit on this in the past, but a post on common vs. preferred stock and how they get diluted when raising new money would be very helpful. Could even weave in some commentary about ‘The Social Network’ 😛

    1. fredwilson

      i won’t see the social networki like either fiction or non fictionbut not fiction that purports to be non fictioni did post on dilution a few weeks backhttp://www.avc.com/a_vc/201…

  14. Chris Clark

    I can’t wait for the 409a discussion. That’s a topic that I’ve tried to wrap my head around, but every explanation I run across gets bogged down in legalese. This post is also great – I thought I understood employee options well, but there’s always more to learn. I didn’t know, for instance, why vesting is better compensation than annual grants.

  15. Emmanuel Bellity

    Very helpful, waiting for the next onethks

  16. Josh Freeman

    Fred: Would be interested in your views on a question that I originally posted on Quora (http://www.quora.com/Are-th… regarding the Netflix practice of allowing employees to just take a portion of their salary to invest in stock, rather than granting options. Have any of your companies done this? What do you think of the practice?

    1. Dan Walter - Performensation

      Hi Josh,I just added an answer to your question on Quora.Dan

    2. fredwilson

      it is interesting but i worry that not enough will roll the cash into stock

    3. Pat

      Netflix employees have a market to sell the stock if they chose to take options and exercise them to get actual shares. For startups, there is no such market.Only founders and C-level employees should value the options. Everyone else will be diluted to nothingness in all probability.

  17. TedHoward

    Could you also address NSO vs ISO? Also RSU’s and SAR’s (Restricted Stock Unit, Stock Appreciation Rights)?I know what they are, along with knowing the options greeks, but I think those will be common enough questions to make them worth addressing. Also, thanks for all the great knowledge and wisdom.

    1. Dan Walter - Performensation

      Ted,While I am sure Fred will provide posting on all of the above, I wanted to let you know about a matrix I put together to help people understand the common types of equity compensation and issues for each.You can find it here: http://www.slideshare.net/p

      1. JLM

        Great stuff!

      2. Dave Pinsen

        I just bookmarked that in case there’s an open book test on this later.

      3. Donna Brewington White

        Where have you been all my life? This is fantastic!

      4. ShanaC

        Thank you Dan Walter

      5. Dan Walter - Performensation

        Thanks to everyone who liked the matrix. There is also a a matrix for performance-based equity on my slideshare account, as well as presentations on these topics. Equity compensation is pretty much what I do. I enjoy most working with small companies, start-ups in particular. I often work remotely and have clients all over the country.I will also try to watch this site closely to provide another perspective on Fred’s great point of view.

        1. Peter Beddows

          Terrific presentation Dan: Well laid out; great detail. Obviously you put a great deal of work into creating this.Thank you.

      6. fredwilson

        whoa, awesome!

        1. Dan Walter - Performensation

          Thanks Fred! Let me know if you want or need more information like this. It’s pretty much all I do.

  18. Dan Walter - Performensation

    Jonathan,I put together a quick access matrix on the Design and Use of Equity Compensation. here; http://www.slideshare.net/p

  19. Dan Walter - Performensation

    Fred,Great post from a real-world point of view. I am a consultant how has worked in the equity compensation world for more than 15 years and I find your summary to be clear and practical.One key regarding stock options and start-ups is having an understanding of the “monetization event”. I don’t like referring to this as an “exit strategy” since many companies and individuals are not looking to exit as much as they are looking for a way to get back some piece of their sweat equity in cash or some other tool that has realizable value.Options are not always the best tool for this, although they can often be the most lucrative and easy to manage. Entrepreneurs should take great care before the jump into a stock option program. If they have good VC advisors like yourself, they should listen. If not, they may want to ask far more questions than I find to be typical.I look forward to your future postings.Dan Walter

  20. JLM

    Remember that stock options are an ingredient in what should be a well thought out and balanced compensation plan using cash compensation, benefits, short term incentive compensation and long term incentive compensation.I fear that everybody thinks that long term compensation — which is where I think stock options fit — is the secret sauce. If so, give them a big helping and count yourself blessed.You have to be able to attract the right people, to motivate them, to get them to be productive and to retain them. That is the purpose of every compensation decision you make.There are a couple of important and pragmatic things which must be remembered:YOU write the stock option plan and your can revise it (not recommended by me) and you can make your plans annual (2010 Stock Option Plan can have different features than the 2011 Stock Option Plan).I like to change the plan entirely rather than go back and revise an earlier plan. A Stock Option Plan probably needs to be revised every 3rd year and has a shelf life of 2 years.I am very surprised to hear talk of “monthly” vesting of options as I consider that to be inconsistent with the long term comp nature of a good plan.I think the vernacular is more “annual vesting” and “cliff vesting” with annual vesting being obvious (every year on a date certain, why not 12-31-year end?) and cliff vesting being “all or nothing” come EOY 5 years hence.I personally favor long term cliff vesting as it gets everybody tightly in the scrum and pushing for the pay window at the same time.Deal with what happens when someone is terminated for cause, resigns to pursue another opportunity or is laid off. I think you lose your options if fired for cause or if resigning before full vesting. Laid off is probably not that important because the company is probably not thriving anyway.When you do cash in options, offer a “cash less” exercise wherein you take back enough options to fund the balance of the exercise.Again, stock options are only one arrow in your comp quiver.Word of caution to founders — there are special rules pertaining to options (“non-qualified” options) for owners of more than 10% of the common.

    1. Tereza

      I’ve been hearing “monthly vesting” quite consistently from my friends who are successful start-up entrepreneurs and this is what they have advising me. What they say is it’s optimally a 3 to 4 year period, with a cliff at one year, and then the monthly vesting. And that for early team members you might start their clock early, such as when they started, so they get to year 1 faster than the later entrants.Their reasoning behind the monthly vesting is that in the start-up environment is so small, a single bad apple can spoil the bunch real fast. Even if there’s not cause involved, you don’t want (and don’t have time for) them to stick it out to the end of the year to vest. It tends to be extremely mutual and known when it’s not working, so don’t let your vesting plan be glue that’s counterproductive.

      1. JLM

        I am quite surprised at the fear that employers have of firing employees. While I have not fired a bunch of employees in the last decades, I am always ready to do what is right. I did fire one two weeks ago.Most employees who get fired, fired themselves.If you think equity is going to be worth something, then I would make it tough to get to the pay window.I believe in cliff vesting at the4-5 year level.If one gets fired for cause or resigns, then the options never vest.

        1. Tereza

          Actually, funny story, that you’ll probably appreciate, JLM.My husband went to get his “masters in business administration” expecting that he was going to learn about “management”. HA!He had worked in restaurants for 5 years, rolling out new locations, worked front of the house (where he dealt with thousands of ornery customers), and back of the house (where he’d at times cut himself and also singed off the hair on his forearms).Then he moved into gourmet food retailing and ultimately ran the flagship store for what was the best franchise in the business at the time. But he was topped out and wanted to move to “HQ”. They weren’t open to it because he was from “the field” and didn’t have a “business background”. Very much a class/positioning thing. (My husband, mind you, put himself through William & Mary, pre-med biology major whose great crime was he decided he didn’t care for medicine) Over ten years the cumulative number of employees he managed certainly hit the thousands. As you can imagine, many of them minimum wage, and very high turnover.Anyway, my Darling Husband, who’d been delivering razor thin P&Ls for a decade walks onto campus at Well-Known-MBA-Program for “business school”. He loved the program and we have both happily hired many of their alums since. But he still jokes that he was the ‘diversity candidate’. LOL.In the first quarter there was a core class called Managing People or something like that. All these people are yacking about what they’d do, hypothetically, with this problem person or that behavioral issue. Yak yak yak.Darling Husband (DH) raises his hand, with an incredulous look says, “Have any of you EVER managed anybody before?”. They shake their heads. Including the professor. DH says, “I’d definitely fire the guy.”. The class gasps. Including the professor. Someone asks, haltingly, “Er, have you ever actually fired anyone before?”My DH stares down the classmate: “Are you kidding? I can’t even COUNT the number of people I’ve fired.”.What he couldn’t believe was that no one in the room had fired anyone before. A “did I make a huge mistake signing up for this program” kind of moment.Another collective gasp from the room.From then on his classmates fell into two camps: the ones that thought he was a total badass, and the ones who thought him rawther insensitive. LOL.In reality, though, he’s very skilled at it. Like an elevator pitch, practice helps. He’s respectful, quick, and genuine in wanting to help them.Often, they thank him.

          1. Aaron Klein

            I hate firing people, but I have gotten a lot better at dealing with it. The last one, the guy breathed a sigh of relief and said “oh good. This was really not working out.” Had to laugh!

          2. ShanaC

            Know thyself when it comes to jobs

          3. JLM

            Perfectly consistent w/ my experience as most people fire themselves and know it. The sigh of relief was undoubtedly long overdue and was truly a relief.

          4. Aaron Klein

            Very true. At least with this one, I didn’t make the same mistake as my first bad hire.(I waited a ridiculous nine months trying to create chances and opportunities to succeed. My eternal optimism was forever tempered after that experience.)

          5. fredwilson

            i pretty much only fire CEOskind of a strange world i live infiring CEOs is not fun, i hate it, but it is something i have to do from time to timeand the reaction is rarely a sigh of relief although it should be most of the time

          6. JLM

            The inefficiencies and wackiness of the real world v the academic world of business education is one of the great mysteries of life to me.B-school should probably be one step removed from vocational education with frequent visits to bone up on the latest advances and to focus on specific topics.I am amazed that there is not a single well spring of education on many of the topics Fred has covered under the guise of MBA Mondays.I suspect the consulting world has kept the lid on it, but I could be wrong.

          7. Peter Beddows

            Those that can, do; those that can’t, teach!

          8. Pat

            Those that can’t do it – can NOT teach. I never met a qualified teacher who couldn’t do.The real teachers can do. And conversely if someone can’t teach then it is likely they cannot do either!The hardest interview question I give to a candidate is “Teach me something”

          9. Peter Beddows

            Pat: Is your reply in defense of you Mom or are you also a teacher that “can do it”? I’ve noticed your comments relative to “waiting for Superman” yet from your other comments, you appear to have a business background. Whatever it is,you feel quite strongly about defending against my comment and I welcome that.I fully realize that my “Those that can, do; those that can’t, teach!’ is a trite and amorphous statement leaving one open to the need to explain exactly what is meant by using it yet it has a certain simplicity that is not, from observation, without a grain of truth behind it. I also accept that there are always exceptions to any so called “rule”.In the case of business, there are many in academia who would teach about business yet have never actually had to start or run a business. Every business has its own peculiarities and thus, while concepts and principles in general can be applied like butter on bread, in many cases, the specific application of those ideas needs tweaking in a way that only if you’ve had direct practical, hands-on people, resources and finance experience in the game as a player will you know what is needed, how and when in real time and real terms.As you most likely know well, there is no one-size-fits-all in-practice sets of answers to running business; it does not come even from having an MBA which, in many cases, can even be counter-productive: It comes from experiences gained while being in the trenches.

          10. Peter Beddows

            I would not mind betting that, in this day and age, “the ones who thought him rather insensitive” significantly outnumbered “the ones that thought he was a total badass”.

          11. Tereza

            Not to put words in his mouth but I think that’s the rub. There was a tendency to keep people at arm’s distance….a hope that by ignoring it the problem would go away.Kind of a dirty or uncomfortable and they were hoping to not have to deal with firsthand. Spreadsheets are cleaner.

          12. Peter Beddows

            Yup! Understand perfectly and not surprised. Life is truly messy isn’t it? (that’s rhetorical) lol

        2. Peter Beddows

          I have to say that I am NOT surprised at the fear that employers have of firing employees.Having hired and fired in a number of situations – including even under Union constrained situations which is a real palaver – and having even cut short interviews when it became obvious that the candidate was not a potential hire, for me the issue is simply one of “it’s business, it’s not personal”. We are not playing games! If an employee is not working out in a particular position yet has shown to have skills and abilities more suited to another position for which we have a need or if additional training may be appropriate, then those considerations are taken into account, otherwise the employee is terminated. End of story: It’s only business.However, I’ve seen how, for many others today, having to handle this task is fraught with diversionary, distracting emotional issues that effectively dis-empowers those charged with the responsibility for managing their team leaving them unable to take action except literally after the horse has left the proverbial stable or after the ship has hit the rocks. Pick whichever metaphor works better for you: Either way, the action is often too late and consequence already made more difficult to resolve. Fortunately, many states, including California, have “At Will” employment laws which makes the issue of firing so much easier to handle if the contract of employment of the respective hired individuals has been written appropriately.We now live in an age wherein it has become de rigueur to be a “friend” to the children instead of being a “parent” to the children: I’ll bet that this strangely warped idea of relationship to the children, which teaches the children in turn that “friendship” is what counts in a relationship as distinct from “respect”, is what carries over into many business situations today wherein the owner/founder, and on down through various managers of people in the business, seek first to select/hire and work with those with whom they can be “friends” and thus with whom they then act as if they are friends. How then subsequently are they to “fire” their “friends”? It wont happen!Secondly, as Tereza’s account here of her husband’s experience in pursuing his MBA, business schools do not teach hire/fire issues and the teachers themselves most likely have never encountered such situations in any real business circumstance outside of academia.Hence, if stock options are to be involved in a compensation package, then:1) They should vest on a minimum of a 1 year from date of hire and then subsequent on a hire-date anniversary yearly cliff schedule from date of commencement of hire.And, even if stock options are not part of the compensation package, 2) The new hire should be on a minimum of a three month probation before confirmation of hire.3) There should be a maximum of 11 months from date of hire for first thorough performance review and there should be subsequent performance reviews at every 12 month interval thereafter so as to dispense with services of subject before the next vesting date if performance warrants termination.4) There is technically no “minimum” period before any performance review should be conducted if, at any time, the subject shows signs of generally failing to meet standards and expectations at which point a formal “perform or resign or termination” edict should be issued.A bad hire can bring the whole team and business down especially in a startup or relatively small business: It is just not worth taking that risk because someone misguidedly “feels” that “we need to be considerate of …. for whatever reason” because that sends the wrong message to all others involved who will, inevitably, be very well aware of who is contributing and who is not. A re-assignment of the person can always be entertained but should include further probationary conditions to ensure you are not just shuffling the deck and burying horse pucky under the blanket.In my view, avoiding potential problems downstream starts with ensuring that the hiring process is clearly understood and well managed. My blog about “Team Meritocracy? Team Diversity? ~ Can the former be achieved if the latter is a constraint?” http://bit.ly/96ZKw7 addresses these issues.Nonetheless, human nature being what it is, it is virtually impossible, even with the best will in the world, not to occasionally slip up and hire someone who must subsequently be fired because you cannot hope to catch everything about the new hire during recruiting ~ as in dating, most everyone can appear to be a “good catch” until the deal is sealed and even thereafter for at least a little while longer which is why a probationary period is essential ~ but with clear guide lines and careful management of the hiring process, you can at least minimize the potential for having down stream problems.And, even after all that, if downstream, a problem emerges, then you must act decisively, directly and swiftly to deal with the situation even to the extent of firing the subject if that is what must be done to save the team and the business. Remember, It’s only business but if it is your own business, are you prepared to risk it all because you can’t risk the emotional burden of having fired a failed hire?

      2. Dan Walter - Performensation

        Monthly vesting can be great when you do not have a lot of transactional volume (read: “private company”), but can be difficult once you are public. Monthly vesting can also make for messy process of corporate actions like reverse splits.It is also important to note that if you call under IFRS2-style financial reporting (like for all companies in the next 3-5 years), monthly vesting becomes much more burdensome from an accounting perspective.Allowing for Early Exercise is a trend that goes up and down about every 3 years. It can be great, but is also fraught with potential problems. One of the great aspects is the ability to lower AMT on ISOs prior to an IPO. One of the biggest problems is ending up with “shareholders” that turn out to be angry ex-employees.

        1. JLM

          A stock option plan provides for a “plan administrator” who is often empowered with the ability to waive just about anything based upon a “one off” entreaty.As a plan administrator myself, I have often waived provisions of a plan which unnecessarily put a bit of sand into the otherwise well lubricated gears of employee compensation and retention.

          1. Dan Walter - Performensation

            JLM. The role of the formal Plan Administrator become more confined as a company moves to going public and is quite confined after a company goes public. Compliance and Accounting issues are becoming more stringent. Issues like the stock option back-dating scandal a few years ago were caused, in part, by well meaning executives and BOD members circumventing the basic rules of their plan.For every Plan Administrator that truly understands and adheres to the rules internal and external to their company there is another who causes serious issues when they “think” they are doing the right thing. I am not saying you are wrong, just reminding people to be careful.

      3. fredwilson

        i like monthly vesting once the one year cliff has been passedi don’t want people sticking around for the wrong reasons

    2. Donna Brewington White

      “I think you lose your options if fired for cause or if resigning before full vesting.”That’s been my observation — at least with regard to resigning before vesting.JLM, when I read your comments on compensation, I appreciate them all the more because I perceive this within the context of what you’ve shared about your company’s culture and how you treat employees. Wise thoughts in themselves but even more so when coupled with your other policies.

  21. Peter Beddows

    Being passionate about building business I have welcomed situations in which my contribution to the effort of growing a client business stands to increase the ultimate “in the money” value of the vested options over the strike price “cost” over time and thus ultimately providing, in effect, a “dividend” in return for that contribution.However, there is an obvious potential downside to having any reliance upon this method of reaping a “bonus” over time ~ there are no guarantees that a) the “in the money” value will ever exceed the strike price let alone not sink below the strike price and b) that we can actually influence the outcome regardless of our very significant “knowledge/experience/guidance/effort” contribution.Hence, in any situation where “stock options” are offered as part of a compensation plan, it always behooves the offerree to critically evaluate to the greatest degree possible before committing – rather than view through rose tinted glasses – the viability of the business proposition rather than be persuaded by dreams of “making a killing” through a possible ultimate IPO or sale of the company that might never happen.

  22. Dan Cornish

    Many potential employees do not believe that stock options will be worth anything. I think it is more important to convince employees that the business is a place to be to fulfill their work lives, to pursue new adventures and to earn a good living. I think giving employees with stock options makes everyone focus on the destination and not on the journey.To throw a few bombs here, stock options help align employees with the investors by focusing on the goal of an exit. But with few exits available, how real are the options. So after the initial excitement wears off and the goal of an exit becomes more distant, the employees become less incented to perform, because the options “will never be worth anything.”Finding a great employee, who loves the job and who makes a good salary if worth far more than an employee loaded up on options looking for an exit. In my opinion, options are a small part of the compensation scheme unless the company is Twitter or Facebook.

    1. Pat

      Hi Dan –I agree with your point “Many potential employees do not believe that stock options will be worth anything.”My own experience backs this up. Any non-founder who thinks that their options are going to be worth anything is delusional. Fred should be complete and show just what happens to an employee’s stock after a couple of downrounds and reverse-splits.My wife’s company just went through a 15000-for-1 reverse split that effectively wiped out everyone except for the latest VCs.Even if a company never has a downround. Just normal follow-on investments pretty much wipe out all early employees.Consider this scenario: * an employee has 10million shares of the-next-YouTube.com * The employee leaves * The-next-YouTube.com goes through 4 funding rounds (seed, A, B, C) of VCs taking 40% equity.The employee’s position is reduced to the same as if he joined after the series C and got 256,000 shares.This is of course neglecting the VC’s liquidation preference. Factor that in and maybe the employee can buy a latte with his options when they can finally be sold.Everyone wants to believe the stock is worth something but the only way options would be valuable at all is if :* no VC money is taken ( and preferably no angel money ) and/or* no liquidation preference for investors* the company is a late-stage company that is likely to experience an exit before another funding round.

      1. paramendra

        I guess a lot of people end up thinking Google and Facebook when the talk is stock options. Most startups have nowhere close to similar a story. And hence the grumpiness.

      2. fredwilson

        our portfolio has the following outcomes distribution1/3 will be worth nothing. employee options will be worth nothing1/3 will be worth something but not much, options will be worth something but not much1/3 will be worth a lot, options will be worth a lot

  23. paramendra

    The formula of how the options are given out look a little haphazard to me from a distance, and that is not a comment on this particular post.

  24. paramendra


  25. Cocktail Dresses

    I know what they are, along with knowing the options greeks, but I think those will be common enough questions to make them worth addressing.

  26. Donna Brewington White

    Really appreciate this series on equity, Fred — for a number of reasons. I’ve been seeing this from a different angle because just about the time you began this series I began a candidate search in which equity issues play a fairly prominent role both in the job responsibilities AND the compensation package. I had become a bit rusty on the subject, but thanks to AVC, I’m getting back up to speed!Today I spent a chunk of time deliberating over a someone’s options and RSUs relative to what my client can offer and saw both the retention and attraction factors playing out real time!Interestingly, one of the companies I’m recruiting from was a client a decade ago when it was pre-IPO and stock options were a key attraction to job candidates and helped make my job easier. Now, on the flip side, I’m seeing those options working against me as a retention tool…but only to an extent…It is interesting to note that even with a generous equity program, this does not make up for a culture that no longer truly values its employees — or at least that is how it is perceived and that is what matters.

    1. JLM

      No good deed goes unpunished.

      1. fredwilson

        one of my favorite quotesi have found this to be sooo true JLM

    2. Dan Walter - Performensation

      Donna,Your final sentence is very true.”It is interesting to note that even with a generous equity program, this does not make up for a culture that no longer truly values its employees — or at least that is how it is perceived and that is what matters.I always tell companies that if you want equity to work, first you have to create employees who think and feel like owners. Equity can be the glue that holds that feeling together, it is seldom the catalyst that creates an ownership culture.Too many companies see equity as a solution to a problem. It works much better as a sweetener to something that is already good.

  27. Brian Manning

    Fred,As you’re thinking about writing other posts on this topic I think it would be very useful to see a post where you lay out the various exits for the average employee at a tech startup. I would love to see a breakdown of the various exits (IPO, acquisition, no gain in equity value, etc.) as well as your thoughts on the likelihood of each. Also a summary of what events can impact the common employee’s option value — dilution, preferred stock, complex deal terms with institutional investors, etc. I don’t recall ever reading a good summary of what equity at an early stage company means for the typical employee on a very practical level — i.e. what are they likely going to end up with after an exit. My take is that, generally, options are overvalued by entrepreneurs and employees — most employees end up with nothing. Would be interested in your take.Think it would be a popular post.

    1. Sloth

      Popular for potential employees, yeah.For founders and VCs….maybe not so much.Running through those scenarios for most typical (or even large) exits will show potential employees that for anything less than an absolute home run, their options are not worth very much at all, especially once they factor in tax treatments – as you note.

      1. fredwilson

        see my comment to brian above

    2. fredwilson

      that’s what i am working towardi did lay out a probability model in another commenthere’s the linkhttp://www.avc.com/a_vc/201…

  28. RJ Johnston

    Thank you for taking the time Fred, informative as always.

  29. Moe

    Your next and previous buttons are AWESOME. Just letting you know 🙂

    1. ShanaC

      I actually wish they were the reverse direction. I keep thinking previous is yesterday…

      1. fredwilson

        at some point, you will train yourselfit took me a while

        1. ShanaC

          No I did- it’s one of those funny things about arrows and the words previousand next- in design on the internet they kind of mean a direction, becausethere isn’t a true sense of left/right or linear time.

  30. Sloth

    It would be worthwhile examining the effect of dilution and/or business setbacks on retention / recruiting. It’s important for founders to consider that if they base a lot of their employee compensation on options, adverse events can cause a nasty double whammy. Have a large setback, you already have nervous employees. When a large chunk of their compensation is perceived to be options, and those options are suddenly devalued (either in reality or in perception) you have got to fill that void, and it is exactly at this time when your option currency is also devalued.That leaves you with non-option compensation, which is probably going to be cash.Since you just had a setback, cash is probably thin on the ground.Rock, meet hard place.

    1. fredwilson

      this seems to be a common theme in this posti wrote about dilution a few weeks agobut i still sense a feeling that options are going to get so diluted that they are worthlessthat is not my experience

  31. perfy

    Fred,I don’t post often, but as someone finishing up my MBA, I’ve enjoyed your MBA Monday series. Some posts interest me more than others, and some leave me excited for the next week. Overall a really nice product you’ve put together.

  32. fredwilson

    that’s what the one year cliff is for

  33. fredwilson


  34. IWO

    I’m a little late to the party but wanted to make two points.First: Amongst my co-founders, we called options “moon dollars.” They might be exchangeable to real dollars at some point down the road, but no one knows what the exchange rate will be, or if an exchange will even be possible. Using that term helped put things in perspective.Second: Every prospective employee has their own motivations and their own risk tolerance. We offered our hires a sliding scale of salary and equity, where the equity went up exponentially based on a linear decrease in salary. This allowed the employee to express his/her own tolerance for risk. More importantly, each employee was fully bought into their compensation because they had a key role in choosing it. (Of course, we laid out the curve based on their experience and level.)I think many smaller startups do this, probably less so as they grow–but it worked for us.

  35. Richard Price

    Fred, do you know why the IRS is happy to waive tax on option grants where the strike price is fair market value, even though such options have financial value? Is it because they recognize the role options play in incentivizing employees, or is there another reason that they have?

  36. Визитки срочно

    The formula of how the options are given out look a little haphazard to me from a distance, and that is not a comment on this particular post.

  37. Bruce Brumberg

    It’s also important to know whether you are granting (or receiving) incentive stock options (ISOs) and/or nonqualified stock options (NQSOs). The rules the company must follow are different, as is the tax treatment at exercise. For a useful website on employee stock options, with good coverage of the taxes, see http://www.myStockOptions.com .

  38. awaldstein

    Thnx Charlie…my point exactly and my experience as well.I’ve been through this a lot and I guess, you need to just put in the time and walk through it.Amazing thing is that most people just don’t ask at all. I always question when senior hires don’t know.

  39. Chris Clark

    Will do, thanks for the suggestion. Here’s the link for anyone else interested: http://www.feld.com/wp/arch