Posts from Vest

M&A Case Studies: Feedburner

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.


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 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!

#MBA Mondays

Employee Equity: Vesting

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.

#MBA Mondays