Nearly 50 years ago, Silicon Valley introduced, among many other things, the practice of granting employees equity as part of their compensation package. Since then, the terms of earning your equity over time has remained largely unchanged. A common example of a vesting schedule is “four years, with a one year cliff,” which means that you earn your equity grant evenly over 4 years, except none of it is yours until you’ve passed your one-year employment mark.
With so much change over the years, it’s important to look at why the vesting schedule exists, what’s changed, and how it has been impacted.
According to the National Venture Capital Association, the median time to IPO was 3.1 years in 2000. Employees were granted equity that would vest until the company would go public, or even beyond that date – four years from when the employee started. Employees’ incentives and timeline were tied to that of the company. There were no (or perhaps very limited) issues of employees struggling to afford their exercise or pay AMT taxes. Publicly traded stocks make a cashless exercise a no-brainer and lower valuations while companies were still private kept exercise costs within reason. This vesting schedule seemed to work pretty well.
Today, venture backed companies are now waiting a median of eleven years after securing their first VC investment to IPO. Not only does the four-year vesting schedule not line up with the time to exit but other problems have been created in the process:
- Companies now must give additional grants to retain employees after their initial 4 years are up. This can cause attrition if not handled properly.
- Equity vests over 4 years, but options typically expire within just 90 days of leaving a company.
- The strike price on grants continues to increase as the private market valuation increases. In many late stage companies, employees simply can’t afford to exercise all of their options, let alone pay the subsequent tax bill.
So what should we do?
First, companies' and employees' incentives need to be aligned. Employees are awarded equity as compensation to encourage them to work hard and build that equity into something meaningful. A four-year horizon doesn’t quite line up with that anymore. Companies can offer new grants, but the employee who took a risk joining a smaller company 4 years ago is forced to pay a significantly higher price to own those new options. Or by the time they receive a new grant they may be considering other paths. Some thoughts to consider: Should the vesting schedule be lengthened? Should an employee vest relative to how early on they joined? Should they be able to lock in a lower exercise price at the beginning?
Furthermore, with private company valuations soaring as they stay private longer, many employees can’t afford the cost to exercise their options or pay their AMT Tax bill. This has forced many employees to leave their hard-earned options on the table if they move to another company. Things to consider: Should employees have the right to a cashless exercise? Should the expiration window be extended well beyond the current 90-day mark? Should options be worthless until they are sold and given value?
Companies are staying private much longer and are worth much more while private. As more people are leave high paying professions to help build small companies, new solutions are required to align employee and company incentives and empower employees to access their equity and its value. At EquityZen, we expect to see new alternatives as companies and employees navigate this changing landscape, and remain committed to supporting shareholders of growing private companies.
