Strategies For Managing Stock Option Plans as Startup Valuations Evolve
An emerging startup can sustain momentum only if the new hires are as driven as the existing team. Disparities in motivation can cause internal friction, disengagement, and a decline in morale. Such a work environment can considerably hinder a startup’s growth trajectory.
One proven way to bridge this gap is to offer stock options in a manner that aligns incentives and fosters a shared sense of ownership across the team. However, this approach can be complex as it involves ensuring tax compliance, navigating intricate plan structures, and catering to diverse candidate expectations.
Hence, in this article, we will discuss 7 strategies that can help you manage stock options effectively as your startup scales.
7 strategies to effectively use stock options as valuations evolve
By adopting the following strategies, your startup can stay tax compliant and meet talent needs while also managing dilution effectively.
Regular 409A valuation updates
When you issue stock options, you must establish your company’s fair market value (FMV) using a valuation compliant with the requirements of Section 409A, i.e., a 409A valuation. These valuations are meant to establish the income and the resulting tax liabilities of those who receive stock options.
These valuations are required after every 12 months and after every material event. A material event is any development, such as securing large government contracts or a significant improvement in overall financial performance, that can impact the share price.
Startups whose valuation is growing rapidly are the ones that experience multiple material events in succession. Such startups may need multiple 409A valuations every year.
Since 409A valuations are often time-consuming, startups hire independent appraisers, as it also happens to be the most convenient way to qualify for safe harbor provisions.
Refresh option pools proactively
Startups that grow exponentially must expand their team swiftly. To keep up with these burgeoning talent needs, such startups must use stock options. But your original option pool might become undersized in relation to the expanding talent needs. So, you will need to proactively refresh option pools.
Since options cause dilution for existing stakeholders, you may need board approval to refresh option pools. So, you must start preparing your option pool expansion proposal well in advance of your next major hiring phase.
Another benefit of refreshing option pools is that it allows you to issue new grants to loyal employees whose original equity awards have been exhausted or are nearing expiration. This will ensure that loyal employees keep contributing with sustained vigor and motivation.
Establish the option pool size after accounting for dilution
Stock options are a source of dilution, which is a decrease in the ownership percentage for existing shareholders. This can directly impact the returns of existing shareholders. But dilution might not always be bad. If the employees add more value to the company than the initially expected loss in returns, shareholders would willingly accept dilution.
To strike this balance, you must issue stock options in a planned and deliberate manner as opposed to doing so reactively.
If you are not familiar with financial modelling or simply do not have the bandwidth, you can use round modelling tools to simulate the impact of option pools of different sizes.
Use different vesting schedules
Startups often issue stock options with a 1-year cliff and a 4-year vesting period. In such a vesting schedule, a certain number of stock options vest 1 year after the grant. Then, the rest of the stock options in the grant vest over the 4-year period on a monthly or quarterly basis.
However, such a vesting schedule might not be suitable for attracting talent at all levels of the organizational hierarchy. In certain situations, offering immediate vesting for a part of the grant might be warranted.
You may not always need to go as far as offering immediate vesting to attract top talent. Sometimes, front-loaded vesting or vesting without cliffs would suffice. In front-loaded vesting schedules, a larger percentage of stock options vest in the initial years than in the later years.
If you are worried about employees leaving early or becoming complacent over time due to front-loaded vesting, you can opt for back-loaded vesting. Back-loaded vesting is the exact opposite of front-loaded vesting. Here, a larger percentage of stock options vest in the later years than in the initial years.
Typically, when we present multiple alternatives, we recommend one of these alternatives and present analysis that supports our recommendation. But this is a case where there is no best choice that holds in all scenarios.
Employee expectations, your startup’s needs, and other circumstances can vary at different stages of growth. So, instead of stoically sticking to a particular vesting schedule, you should be flexible.
Invest in employee education
Even the most brilliantly crafted stock option plan will fail to motivate employees if they do not truly understand its value.
For most people, stock option plans are a rare opportunity to gain entry to the private equity market. An added benefit of stock options is that they often allow employees to purchase shares at significant discounts. You must ensure that your employees realize the significance of these benefits.
Sometimes, employees may perceive stock options as an unattainable benefit or a benefit that cannot be fully realized. This is primarily due to complicated vesting schedules and jargon present in stock option grant documents. So, you will also need to educate employees about vesting schedules and the key terms and clauses. You could go a step further and establish channels through which employees could have their doubts addressed.
Furthermore, you should educate your employees about tax-saving practices such as early exercising.
Use non-voting stock-based compensation
Stock-based compensation is not limited to stock options. Non-voting stock-based compensation, such as phantom stocks and stock appreciation rights (SARs), can be structured to provide identical monetary benefits.
A major benefit of non-voting stock-based compensation is that it prevents unwelcome changes in ownership and control. Issuing such compensation essentially limits the shareholding with which third parties can hope to stage takeovers.
To protect your control over your startup, you could also establish a multi-class equity structure. In such a structure, the voting power of shares from each class is different. For instance, you could have three share classes wherein one class of shares has one vote per share, another class has three votes per share, and the final class has ten votes per share.
Facilitate exits
Lack of timely exits can frustrate large investors who manage portfolios worth millions. Naturally, employees with smaller net worths and cash reserves will experience this strain more acutely.
So, you should periodically facilitate exits for employees. Otherwise, employees might become disillusioned, and stock options would fail to motivate them.
The most straightforward way to provide exits would be to buy the stocks owned by the employees with the startup’s own cash reserves.
However, a startup whose valuation is evolving rapidly has better alternatives that do not deplete its own cash reserves. Firstly, you could ask existing investors who wish to double down on their investment to provide exits to your employees. Secondly, in funding rounds, you could request incoming investors to buy out employee shareholding. Such an exit is sometimes offered to early-stage investors, and hence, extending the same deal to employees would not be entirely out of the ordinary.
Eqvista- Streamlining equity management!
As your startup gains traction, managing stock-based compensation becomes both critical and complex. Even seemingly minor missteps can lead to significant setbacks.
To attract and retain top talent while steering clear of disputes and compliance pitfalls, you must stay on top of key elements such as 409A valuations, vesting schedules, board approvals, and option pool size.
Given the high-stakes nature of equity management, you will need a trustworthy partner such as Eqvista. We offer cost-effective equity management solutions with built-in compliance support.
Contact us to learn how we can empower you to leverage equity confidently, whether you are raising capital or competing for top talent!
