Posts from Options

That's how Skype's option plan is described in this piece by Felix Salmon. I've seen option plans that have repurchase rights in them. They used to be more common twenty five years ago when I entered the venture capital business. The theory was that employees would have to stay until the exit if they wanted to keep their equity (be in it to win it). But in practice, once employees realized that was the deal, they were actually incented to leave because they didn't trust that the equity they were vesting would ever produce a payday for them. So they went elsewhere and created value for an employer with a better deal.

Today, the "market" deal in employee option plans is that employees have to exercise their options within some period after leaving (typically 90 days). This is a better deal for the employee than a repurchase right but can still create hardship for employees as it may cost real money to exercise and there are often tax issues with exercising options. This requirement to exercise upon departure is a big reason why the secondary market in employee common stock has taken off. Employees who leave companies need to sell some of their vested stock to come up with the cash to exercise and pay taxes associated with exercise.

This is a tricky area. Companies feel that employees who stay and work to create ongoing value should have a better deal on their vested options than employees who leave and go to work elsewhere. I understand that point of view. But it is also true that your employees need to feel that the options they are vesting are going to be worth something and that they will be able to keep them when they leave.

Companies also want to control their stock and keep it off of secondary markets where they can end up wtih shareholders who they don't know. The requirement to exercise within a short period of departure is in conflict with the desire to control the cap table.

I believe this whole area of "what happens with the options when the employee leaves" needs to be rethought in light of where we find ourselves right now in startupland. I'm not sure I have any particularly good ideas but I know that the way we do it right now is problematic for everyone.

We've talked about this issue before here at AVC. Investors like to require that an unissued option pool is in the pre-money valuation calculation when they put money into early stage companies. If you don't entirely understand what I am talking about here, go click on that link at the start of the post. Hopefully it will explain the issue.

This post is about how to size the option pool. Many investors just want the number to be as big as possible. They'll put 15% into the term sheet and then let the entrepreneur negotiate them down from there and maybe if you are lucky you'll get them to 10%. But there is no logic in that kind of negotiation. It is just a price negotiation disguised as something else. It is bullshit. And I see investors engage in that kind of practice all the time. It annoys me.

What I like to do, as I mentioned in the post I linked to, is agree with the entrepreneur that the option pool will have enough unissued options to fund all the hiring and retention grants that need to happen between the current financing and the next one. Then we'll do the same thing at the time of the next financing. That makes sense to me. And it is pretty easy to do.

Let's say you are raising $1mm at $4mm pre-money. And the investors want the option pool to be in the pre-money valuation. Let's say the $1mm will last you 18 months. Then you determine how many people you are going to hire in the next 18 months. If the financing is $1mm, it's not going to be that many. You probably have three to five employees already. Without revenue coming in, five employees will suck up half of that money over 12 to 18 months. So at most you are going to hire another 5 employees.

Here's a formula I like to use. Take the cumulative salaries of all the hires you need to make betwen the current financing and the next one. Let's say it is five employees at an average of $75,000. Then that number is $375,000. Then divide that number by the post-money valuation, in this case $5mm. That gives you 7.5%. That's the size of the option pool you'll need. And it is conservative because I don't recommend giving options equal to the dollar value of the annual salary of your hires. I like anywhere between 0.1x to 1x (depending on role and responsibility), with the average being in the .25x range. But early on in a company, you will need to and want to be more generous.

This approach assumes you have already granted employye equity to the existing team. Ideally they will have founders stock or restricted stock. But whatever they have, they should be holding sufficient equity to keep them happy and excited to be working in your startup. If that isn't true, you will need to add some additional equity to the pool to take care of them.

The bottom line is that sizing up option pools should not be like horse trading. It should be a science. It should be based on an option grant methodology that is driven off annual salary, and an option budget based on headcount and hiring plans. And if you do it that way, you will end up with a lot less dilution. Which is what you should always be trying to achieve.

This MBA Mondays M&A case study is about the effect that stock option acceleration provisions have on M&A transactions. I am reblogging a blog post that Feedburner founder/CEO Dick Costolo (now Twitter CEO) wrote in the wake of the acquisition of Feedburner by Google. This post is still live on the web at its original location. While the names are fictional, the situations are not. It's a really good read and addresses a whole host of issues that you will face as you think about stock option acceleration for your team.

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Question number 1 comes from an invisible Irish gentleman named Bernie in Wichita. Bernie writes, “Can you explain options acceleration? And when would I want to use it? And when wouldn’t I? And what’s single trigger vs. double trigger acceleration and how do you feel about those kinds of things?”

Those are great questions Bernie! Hopefully, I can at least get you to realize there's a lot to think about here. Let’s dive right in.

Most options plans for your employees have a vesting schedule the defines how the options vest (ie, when the employee can exercise them). Vesting schedules for tech startups all generally look like a four year vesting period, with 25% of the total options grant vesting on a one year cliff (ie, nothing vests for a year and then 25% of the options vest on the 1 year anniversary), and then the rest of the options vest at 1/48th of the total options every month for the next 36 months.

Now let’s say you’ve got this classic vesting schedule and you hire somebody named Bobby Joe after you’ve been in business for one month, and he gets an options grant equal to 1% of the total outstanding shares. He works hard at your company for 11 months, after which your company is acquired for an ungodly sum of money. The acquirer decides that they were buying your company because of it’s cool logo and they don’t need any actual employees so they are all terminated effective immediately.

Bobby Joe’s options are worth how much? If you answered “Bubkas”, “Zero”, “nothing” or laughed at the question, you are correct. Although Bobby Joe has worked at the company for almost the entire life of the company, he gets nothing and the person that started 30 days before him gets 25% of their total options value. Doesn’t seem fair. Or as Bobby Joe would undoubtedly say “I’m upset, and I will exact my revenge on you at some later date in a compelling and thorough fashion”

Enter acceleration. Acceleration in an options plan can cause vesting to accelerate based on some event, such as an acquisition. For example, you might have a clause in your plan that states that 25% of all unvested options accelerate in the event the company is acquired.

If Bobby Joe had acceleration like this, he’s happier. He may still not be as happy as the person hired a month before him who also accelerates and now has 50% vested (the first year cliff and the extra 25% acceleration), but it sure feels a lot better to be Bobby Joe in this scenario.

That brings us to single trigger, double trigger, full acceleration, partial acceleration, etc.

We’ll start with full vs. partial acceleration. Full acceleration means that if the accelerating event happens, 100% of unvested options are vested and the employee is fully vested. If you started your job last Wednesday, the board approved your options grant on Thursday with full acceleration, and the company was acquired on Friday, congratulations, you just vested 100% of your options….you are just as vested as Schmucky in Biz Dev who was employee number 2 and started 3 years and 10 months ago (although shmucky may of course have a larger total number of options than you).

Partial acceleration we already referred to; this is how we refer to vesting some remaining portion of unvested options, such as 25% of the remaining unvested options.

Ok so far? Good, we are coming to the fun part. Let’s say you bootstrap your startup that’s selling bootstraps on bootstrap.com for two years and then let’s say you have a 20% options pool that was created as part of an A round financing. Over the next 6 months you hire a whole bunch of people, you allocate 15 percent of the options pool, and an acquirer comes along. Do you think the shareholders (common and preferred) are going to be more excited about full acceleration or partial acceleration? Full acceleration dilutes the shareholders 15%, whereas partial acceleration only dilutes the shareholders…well, partially. As a variation on this example, let’s say you hired employee number 1 when you started bootstrapping and you allocate the same number of options to everybody. The guy who started last Tuesday is going to make just as much as employee number 1.

For these kinds of reasons, you will frequently see investors and others argue for partial acceleration. Options holders and those negotiating their employment of course prefer full acceleration. This can be the cause of lots of board arguments in the early going as you and your investors decide how acceleration will work in your company options plan (or with employees who want to negotiate additional acceleration on top of the existing plan). Hold this thought for a moment while we hop across town to learn about single trigger, double trigger, etc.

Single trigger acceleration simply means that there is one kind of event in the options agreement that triggers the acceleration of some or all options. Single trigger usually refers to an acquisition. Double trigger (and I suppose triple and quadruple trigger) acceleration means that there are multiple kinds of events that can trigger the vesting of options. Double trigger acceleration usually refers to a situation in which the options plan grants partial acceleration on an acquisition, and then further acceleration (perhaps full, perhaps additional partial) if the employee is terminated (eg, our first example where they’re buying the company for its logo and don’t need employees).

Now for the important piece of the conversation: What’s the best way to set up an options plan vis-à-vis acceleration? The idea behind double trigger acceleration is that as we saw in our bootstrap example, there are lots of interested parties that don’t particularly care for full single trigger acceleration. It is very employee friendly BUT not necessarily equitable and your investors will very likely raise their hands at every board meeting and ask if you’ve come to your senses yet if you’ve started your plan with full single trigger acceleration. We’ll see another reason to dislike it in a minute. So, along comes double trigger acceleration in which we seem to be creating a more ‘fair’ plan because partial acceleration makes the shareholders happy and the employees who’ve worked there for a couple years get a bigger piece than the guy who started Tuesday, while also providing additional consideration to any and all employees who aren’t offered jobs after the acquisition.

Here’s how I feel about all this, from number of options granted to acceleration: I’m for partial single trigger acceleration on acquisition (with no special exemptions for employees with super powers) AND an options grant program that objectively matches role and title to size of grant consistently across the organization. (eg, all senior engineers get 4 options, all executive team hires get eleventy-eleven options, you get the picture).

Why? Because any other approach misaligns interests and motivations. I know of one company (not one I started or worked for) that had full single trigger acceleration and the people at this company STILL hate the head of sales that got hired one month before an acquisition and made more than the hundreds of people who’d worked there for three years. Double trigger? Now you’ve got people who might WANT to get terminated if there’s an acquisition. Subjectively granting options quantities based on whatever the criteria of the day is? Always a bad idea and bound to end in tragedy and you regretting your whimsical approach to options grants.

So, at this point the astute reader thinks “this is all well and good, but you can just as easily have some employees who really take a bath if they’ve just left a very nice and respectable job to come work for you, then get terminated on acquisition a month later, and only get partial single trigger acceleration”. This is true. The answer is hey, they get partially accelerated, and I’d rather have generally equitable distribution of the deal. If you’ve got a reasonable Board of Directors, you can accommodate anomalies with performance bonuses or severance or whatnot instead of being locked into a plan with misaligned interests.

There’s another hidden issue with full single trigger acceleration that I mentioned earlier, and we can call this the “acquirer’s not stupid” rule. If your employees all fully vest on acquisition, how do you think the acquirer is feeling about your team’s general motivation level post-acquisition? They are not feeling good about it. No they are not. They are thinking “gee, we are going to have to re-incent all these folks and that’s going to cost a bunch of money, and you know where that money’s going to come from? I think we will just subtract it from the purchase price, that’s what we will do!”….so the shareholders get doubly-whacked…they get fully diluted to the total allocated options pool AND they likely take a hit on total consideration as the acquirer has to allocate value to re-upping the team.

My FeedBurner cofounders and I have done our options plans a bunch of different ways across a few different companies, even changing midstream once, and I think partial single trigger acceleration causes the least headaches for everybody involved in the equation (although it obviously provides less potential windfall for more recent hires).

NB: you should be very very clear when you hire people about how this works. Most employees, to say nothing of most founders, don’t really understand all the nuances in an options plan, and it’s always best to minimize surprises later on.

You want to sort as much of this out up front with your attorneys before you start hiring people. You want to avoid having “the old plan with X and the new plan with Y” and that sort of thing.

Thanks for the note, Bernie!

The most common comment in this long and complicated MBA Mondays series on Employee Equity is the question of how much equity should you grant when you make a hire. I am going to try to address that question in this post.

First, a caveat. For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula. Getting someone to join your dream before it is much of anything is an art not a science. And the amount of equity you need to grant to accomplish these hires is also an art and most certainly not a science. However, a rule of thumb for those first few hires is that you will be granting them in terms of points of equity (ie 1%, 2%, 5%, 10%). To be clear, these are hires we are talking about, not co-founders. Co-founders are an entirely different discussion and I am not talking about them in this post.

Once you have assembled a core team that is operating the business, you need to move from art to science in terms of granting employee equity. And most importantly you need to move away from points of equity to the dollar value of equity. Giving out equity in terms of points is very expensive and you need to move away from it as soon as it is reasonable to do so.

We have developed a formula that we like to use for this purpose. I got this formula from a big compensation consulting firm. We hired them to advise a company I was on the board of that was going public a long time ago. I’ve modified it in a few places to simplify it. But it is based on a common practive in compensation consulting. And it is based on the dollar value of equity.

The first thing you do is you figure out how valuable your company is (we call this “best value”). This is NOT your 409a valuation (we call that “fair value”). This “best value” can be the valuation on the last round of financing. Or it can be a recent offer to buy your company that you turned down. Or it can be the discounted value of future cash flows. Or it can be a public market comp analysis. Whatever approach you use, it should be the value of your company that you would sell or finance your business at right now. Let’s say the number is $25mm. This is an important data point for this effort. The other important data point is the number of fully diluted shares. Let’s say that is 10mm shares outstanding.

The second thing you do is break up your org chart into brackets. There is no bracket  for the CEO and COO. Grants for CEOs and COOs should and will be made by the Board. The first bracket is the senior management team; the CFO, Chief Revenue Officer/VP Sales, Chief Marketing Officer/VP Marketing, Chief Product Officer/VP Product, CTO, VP Eng, Chief People Officer/VP HR, General Counsel, and anyone else on the senior team. The second bracket is Director level managers and key people (engineering and design superstars for sure). The third bracket are employees who are in the key functions like engineering, product, marketing, etc. And the fourth bracket are employees who are not in key functions. This could include reception, clerical employees, etc.

When you have the brackets set up, you put a multiplier next to them. There are no hard and fast rules on multipliers. You can also have many more brackets than four. I am sticking with four brackets to make this post simple. Here are our default brackets:

NOTE: The numbers below are as of 2010. They have moved a lot since then. The Senior Team numbers have moved the most. I would not recommend using these numbers or you will be below market with your employee equity grants.

Senior Team: 0.5x

Director Level: 0.25x

Key Functions: 0.1x

All Others: 0.05x

Then you multiply the employee’s base salary by the multiplier to get to a dollar value of equity. Let’s say your VP Product is making $175k per year. Then the dollar value of equity you offer them is 0.5 x $175k, which is equal to $87.5k. Let’s say a director level product person is making $125k. Then the dollar value of equity you offer them is 0.25 x $125k which is equal to $31.25k.

Then you divide the dollar value of equity by the “best value” of your business and multiply the result by the number of fully diluted shares outstanding to get the grant amount. We said that the business was worth $25mm and there are 10mm shares outstanding. So the VP Product gets an equity grant of ((87.5k/25mm)  * 10mm) which is 35k shares. And the the director level product person gets an equity grant of ((31.25k/25mm) *10mm) which is 12.5k shares.

Another, possibly simpler, way to do this is to use the current share price. You get that by dividing the best value of your company ($25mm) by the fully diluted shares outstanding (10mm). In this case, it would be $2.50 per share. Then you simply divide the dollar value of equity by the current share price. You’ll get the same numbers and it is easier to explain and understand.

The key thing is to communicate the equity grant in dollar values, not in percentage of the company. Startups should be able to dramatically increase the value of their equity over the four years a stock grant vests. We expect our companies to be able to increase in value three to five times over a four year period. So a grant with a value of $125k could be worth $400k to $600k over the time period it vests. And of course, there is always the possiblilty of a breakout that increases 10x over that time. Talking about grants in dollar values emphasizes that equity aligns interests around increasing the value of the company and makes it tangible to the employees.

When you are doing retention grants, I like to use the same formula but divide the dollar value of the retention grant by two to reflect that they are being made every two years. That means the the unvested equity at the time of the retention grant should be roughly equal to the dollar value of unvested equity at the time of the initial grant.

We have a very sophisticated spreadsheet that Andrew Parker built that lays all of this out for current employees and future hires. We share it with our portfolio companies but I do not want to post it here because it is very complicated and requires someone to hand hold the users. And this blog doesn’t come with end user support.

I hope this methodology makes sense to all of you and helps answer the question of “how much?”. Issuing equity to employees does not have to be an art form, particularly once the company has grown into a real business and is scaling up. Using a methodology, whether it is this one or some other one, is a good practice to promote fairness and rigor in a very important part of the compensation scheme.

We had a bunch of questions about vesting in the comments to last week’s MBA Mondays post. So this post is going to be about vesting.

Vesting is the technique used to allow employees to earn their equity over time. You could grant stock or options on a regular basis and accomplish something similar, but that has all sorts of complications and is not ideal. So instead companies grant stock or options upfront when the employee is hired and vest the stock over a set period of time. Companies also grant stock and options to employees after they have been employed for a number of years. These are called retention grants and they also use vesting.

Vesting works a little differently for stock and options. In the case of options, you are granted a fixed number of options but they only become yours as you vest. In the case of stock, you are issued the entire amount of stock and you technically own all of it but you are subject to a repurchase right on the unvested amount. While these are slightly different techniques, the effect is the same. You earn your stock or options over a fixed period of time.

Vesting periods are not standard but I prefer a four year vest with a retention grant after two years of service. That way no employee is more than half vested on their entire equity position. Another approach is to go with a shorter vesting period, like three years, and do the retention grants as the employee becomes fully vested on the original grant.  I like that approach less because there is a period of time when the employee is close to fully vested on their entire equity position. It is also true that four year vesting grants tend to be slightly larger than three year vesting grants and I like the idea of a larger grant size.

If you are an employee, the thing to focus on is how many stock or options you vest into every year. The size of the grant is important but the annual vesting amount is really your equity based compensation amount.

Most vesting schedules come with a one year cliff vest. That means you have to be employed for one full year before you vest into any of your stock or options. When the first year anniversary happens, you will vest a lump sum equal to one year’s worth of equity and normally the vesting schedule will be monthly or quarterly after that. Cliff vesting is not well understood but it is very common. The reason for the one year cliff is to protect the company and its shareholders (including the employees) from a bad hire which gets a huge grant of stock or options but proves to be a mistake right away. A cliff vest allows the company to move the bad hire out of the company without any dilution.

There are a couple things about cliff vesting worth discussing. First, if you are close to an employee’s anniversary and decide to move them out of the company, you should vest some of their equity even though you are not required to do so. If it took you a year to figure out it was a bad hire then there is some blame on everyone and it is just bad faith to fire someone on the cusp of a cliff vesting event and not vest some stock. It may have been a bad hire but a year is a meaningful amount of employment and should be recognized.

The second thing about cliff vesting that is problematic is if a sale happens during the first year of employment. I believe that the cliff should not apply if the sale happens in the first year of employment. When you sell a company, you want everyone to get to go to the “pay window” as JLM calls it. And so the cliff should not apply in a sale event.

And now that we are talking about a sale event, there are some important things to know about vesting upon change of control.  When a sale event happens, your vested stock or options will become liquid (or at least will be “sold” for cash or exchanged for acquirer’s securities). Your unvested stock and options will not. Many times the acquirer assumes the stock or option plan and your unvested equity will become unvested equity in the acquirer and will continue to vest on your established schedule.

So sometimes a company will offer accelerated vesting upon a change of control to certain employees. This is not generally done for the everyday hire. But it is commonly done for employees that are likely going to be extraneous in a sale transaction. CFOs and General Counsels are good examples of such employees. It is also true that many founders and early key hires negotiate for acceleration upon change of control. I advise our companies to be very careful about agreeing to acceleration upon change of control. I’ve seen these provisions become very painful and difficult to deal with in sale transactions in the past.

And I also advise our companies to avoid full acceleration upon change of control and to use a “double trigger.” I will explain both. Full acceleration upon change of control means all of your unvested stock becomes vested. That’s generally a bad idea. But an acceleration of one year of unvested stock upon change of control is not a bad idea for certain key employees, particularly if they are likely to be without a good role in the acquirer’s organization. The double trigger means two things have to happen in order to get the acceleration. The first is the change of control. The second is a termination or a proposed role that is a demotion (which would likely lead to the employee leaving).

I know that all of this, particularly the change of control stuff, is complicated. If there is anything I’ve come to realize from writing these employee equity posts, it is that employee equity is a complex topic with a lot of pitfalls for everyone. I hope this post has made the topic of vesting at least a little bit easier to understand. The comment threads to these MBA Mondays posts have been terrific and I am sure there is even more to be learned about vesting in the comments to this post.

For the past six weeks, we've been talking about employee equity on MBA Mondays. We've covered the basics, some specifics, and we've discussed the main form of employee equity which are stock options. Today we are going to talk about two other ways companies grant stock to employees, restricted stock and restricted stock units (RSUs).

Restricted stock is fairly straight forward. The company issues common stock to the employee and puts some restrictions on the stock. The restrictions typically include a vesting schedule and some limits on how the stock can be sold once it is vested.

The vesting schedule for restricted stock is typically the same vesting schedule as the company would use for stock options. I am a fan of a four year vest with a first year cliff. The sale restrictions usually include a right of first refusal on sale for the company. That means if you get an offer to buy your vested restricted stock, you need to offer it to the company at that price before you can sell it. There are often other terms associated with restricted stock but these are the two big ones.

A big advantage of restricted stock is you own your stock outright and do not have to buy it with a cash outlay. It is also true that you will be eligible for long term capital gains if you hold your restricted stock for at least one year past the vesting period. There currently is a significant tax differential between long term capital gains and ordinary income so this is a big deal.

The one downside to restricted stock is you have to pay income taxes on the stock grant. The stock grant will be valued at fair market value (which is likely to be the 409a valuation we discussed last week) and you will be taxed on it. Most commonly you will be taxed upon vesting at the fair market value of the stock at that time. You can make an 83b election which will accelerate the tax to the time of grant and thus lock in a possibly lower valuation and lower taxes. But you take significant forfeiture risk if you make an 83b election and then don't vest in all of the stock.

If you are a founder and are receiving restricted stock with nominal value (penny a share or something like that), you should do an 83b election because the total tax bill will be nominal and you do not want to take a tax hit upon vesting later on as the company becomes more valuable.

This taxation issue is the reason most companies issue options instead of restricted stock. It is not attractive to most employees to get a big tax bill along with some illiquid stock they cannot sell. The two times restricted stock make sense are at formation (or shortly thereafter) when the value of the granted stock is nominal and when the recipient has sufficient means to pay the taxes and is willing to accept the tradeoff of paying taxes right up front in return for capital gains treatment upon sale.

Recently, some venture backed companies have begun to issue restricted stock units (RSUs) in an attempt to get the best of stock options and restricted stock in a single security. This is a relatively new trend and the jury is still out on RSUs. Currently I am not aware of a single company in our portfolio that issues RSUs but I do know of several that may start issuing them shortly.

A RSU is a promise to issue restricted stock upon the acheivement of a certain vesting schedule. It is a lot like a stock option but you do not have to exercise it. You simply get the stock like a restricted stock grant. And there is an added twist in some RSU plans that allow the recipient of an RSU to delay the receipt of the stock until the stock is liquid. Combined, these two features may remove all of the tax disadvantages of restricted stock because the employee would not have a taxable event until the vesting schedule is over and possibly until the stock becomes liquid. I say "may remove all of the tax disadvantages" because I believe that the IRS has never tested the tax treatment of RSUs.  Therefore RSUs are an "adventure in tax land" as one general counsel in our portfolio would say.

I do not believe there is an optimal way to issue employee equity at this time. Each of the three choices; options, restricted stock, and RSUs, has benefits and detriments. I believe that options are the best understood, most tested, and most benign of the choices and thus are the most popular in our portfolio and in startupland right now. But restricted stock and RSUs are gaining ground and we are seeing more of each. I cannot predict how this will all change in the coming years. It is largely up to the IRS and so the best we can hope for is that they don't mess up what is largely a good thing right now.

Employee equity is a critical factor in the success of the venture backed technology startup world. It has created significant wealth for some and has created meaningful additional compensation for many others. It aligns interests between the investors, founders, management, and employee base and it a very positive influence on this part of the economy. We strongly encourage all of our portfolio companies to be generous in their use of employee equity in their compensation plans and I believe that all of them are doing that.

A few weeks back we talked about stock options in some detail. I explained that the strike price of an option is the price per share you will pay when you exercise the option and buy the underlying common stock. And I explained that the company is required to strike employee options at the fair market value of the company at the time the option is granted.

The Board has the obligation to determine fair market value for the purposes of issuing options. For many years, Boards would do this without any third party input. They would just discuss it on a regular basis and set a new price from time to time. This led to some cases of abuse where Boards set the strike price artificially low in order to make their company's options more attractive to potential employees. I sat on many Boards during this time and I can tell you that there was always a tension between keeping the strike price low and living up to our obligation to reflect the fair market value of the company. It was not a perfect system but it was a decent system.

About five years ago, the IRS got involved and issued a rule called 409a. The IRS looks at options as deferred compensation and will deem options as taxable compensation if they don't follow very specific rules. Due to rampant abuse of the deferred compensation practices in the late 90s and early part of the last decade, the IRS decided to change some rules and and thus we got 409a. The 409a ruling is very broad and deals with many forms of deferred compensation. And it directly addresses the setting of strike prices.

409a puts some real teeth into the Board's obligations to strike options at fair market value. If the strike prices are too low, the IRS will deem the options to be current income and will seek to collect income taxes upon issuance. Not only will the employee have tax obligations at the time of grant, but the company will have withholding obligations. In order to avoid all of this, the Board must document and prove that the strike price is fair market value. Most importantly, 409a allows the Board to use a third party valuation firm to advise and recommend a fair market value.

As you might expect, 409a has given rise to a new industry. There are now many valuation firms that derive all or most of their income doing valuations on private companies so that Boards can feel comfortable granting options without tax risk to the employees and the company. This valuation report from a third party firm is called a 409a valuation.

The vast majority of privately held companies now do 409a valuations at least once a year. And many do them on a more frequent basis. When your company grants options, or if you are an employee and are getting an option grant, the strike price will most likely be set by a third party valuation firm.

You'd think this system would be better. Certainly the IRS thinks it is better. But in my experience, nothing has really changed except that companies are paying $5000 to $25,000 per year to consultants to value their companies. There is still pressure on the companies to keep the prices low so that their options are attractive to new employees. And that pressure gets transferred to the 409a valuation firms. And any time someone is being paid to do something, you have to question how objective the result is. I look at the fees our companies pay to 409a valuation firms as the cost of continuing to issue options at attractive prices. It is the law and we comply. Not much has really changed.

There is one thing that has changed and it relates to timing of grants. It used to be that the Board could exercise a fair bit of "judgement" around the timing of grants and financing events. If you had a big hire and a financing planned, the Board could set fair market value, get the hire made, and then do the financing. Now that is so much harder to do. It takes time and money to get a 409a valuation done. Most companies will do a new one after they conclude a financing. And most lawyers will advise a company to put a moratorium on option grants for some time leading up and through a financing and do all the grants post financing and post the new 409a. This has led to a bunch of situations in my personal portfolio when a new employee got "screwed" by a big up round. It behooves the Board and management to be really strategic around big hires and financing events to avoid these situations. And even with the best planning, you will run into problems with this.

If the company you are joining is early in its development, the strike price will likely be low and you don't have to pay too much attention to it. But as the company develops, the strike price will rise and it willl become more important. If the Company is a "high flyer" and is headed to a big exit or IPO, pay a lot of attention to the strike price. A low strike price can be worth a lot of money in a company where the value is rising quickly. In such a situation, if there has been a recent 409a valuation, you are likely in a good situation. If the company is a high flyer and is overdue for a 409a valuation, you need to be particularly careful.

This whole area of option strike prices is complicated and full of problems for boards and employees. It has led to a growing trend away from options and toward restriced stock units (RSUs). We'll talk about them next week.