Having been on both sides of the negotiation table, I'm increasingly of the opinion that the standard model of granting equity (linear vesting over 4 years with a 1 year cliff) is deeply and fundamentally broken and the only reason anyone ever sticks with it is due to tradition and a fear that any attempt to tinker will uncover how deeply broken it is.
It's a bad system that doesn't serve either side well and the only reason it hasn't blown up into a real issue is because cash is cheap enough right now that most of the deals I'm seeing amount to something like "within 20% of market wage + an insultingly small amount of equity".
I have no pretensions that the ideas I have are any good, feasible or even legal but I think it's at least worthwhile thinking and experimenting with models that serve the needs of both sides better.
Problem: Options are basically impossible to price (and are undervalued). If it costs me as an employer $100K to offer an options package but the employee only perceives it to be worth $10K, then it becomes a major problem using it as a hiring incentive. The problem is that standard option contracts are basically impossible to price. I like to think I'm relatively sophisticated at finance and I've worked through the options packages of a bunch of my friends and I always end up throwing my hands up in the air and declaring that I have no idea how to even approximate a fair price.
What most people far less sophisticated (aka most engineers) do is price on the underlying asset. eg: 4% of a company worth 1M vesting over 4 years equals $4000 of forgone salary (aka: not that exciting). In reality, basic options theory states that an option is always worth more than the underlying asset and the difference is directly dependent on the volatility of the underlying asset. On the flip side, liquidation preferences, dilution, acquihiring and the like drastically depress the value of an option. These two combined make pricing options a black art.
Solution: Think about it, nowhere else in the startup world do we make locked in 4 year contracts, why would you do it with employees? Would you sign a 4 year office lease? Would you commit to a fixed bill for EC2 4 years down the road? Startups are all about paying a premium for flexibility, I'd much rather offer 2% vesting over 1 year than 4% vesting over 4 and I wager employees would value it higher as well. Alternatively, get rid of linear vesting and implement something like 40%/30%/20%/10%. This at least makes refresher grants meaningful rather than a pitiful joke when put against existing options.
Problem: There are huge discontinuities in the standard vesting. At 1 year, your effective net worth suddenly takes a huge jump upwards and at 4 years, your effective salary takes a huge jump downwards (even accounting for refresher grants). These discontinuities are ruinous to employee loyalty. People are pretty lazy, they usually prefer a pretty good job to the effort of finding a better one. But 1 year cliffs and 4 year cliffs are just enough of a nudge to put people casually on the market.
Solution: Get rid of the 1 year cliff. The ostensible reason given for the cliff is that companies don't want to reward employees who don't work out. But you've already paid them a bunch of salary and spent the time hiring and training them!
If the concern is that you don't want them added to the shareholder limit, instead what might be a more elegant solution is that, anytime during the first year, if you leave for any reason, the company has the option to force you to sell back your shares for say, 2x the strike price. For example, say you're made an offer for 1000 shares per month at a $1 strike price and it ends up not working out in 4 months. The company has the option of either letting you keep 4000 shares or paying you $8000 to void the shares. This seems like a way better way to keep all the incentives aligned rather than blunt force cliffs.
Problem: It's easy to give people additional options but hard, and possibly illegal to take options away. On the surface, this seems like a win for employees. But like laws that make it harder to fire people, the perverse incentives make companies more conservative and make it worse for employees. A company that makes a mistake and offers a salary that is too high for an employee's value can at least attempt to re-negotiate and drop the salary. A company that makes a mistake on equity has no choice but to either live with it or fire the employee.
Solution: Making equity grants re-negotiable opens up a can of worms as Zynga discovered. Who knows? I don't have any great ideas about this.
Problem: Standard share grants are a shitty way to compensate for forgone income. Say you're a cash strapped startup and an engineer is willing to work for you as employee #1 for $12K instead of his usual 120K. How much is that worth in equity? It's hard to say since you don't know how long the income is forgone for. You could raise a Series A tomorrow and bump his salary back up to 100K, you could struggle to raise for a year while he gamely hangs on. Is that worth 1%? 4%? 15%? Who knows?
Solution: Agree on two vesting schedules that get switched over automatically upon hitting certain goals. eg: Agree to pay 1K & vest 1% for every month while bootstrapped which gets automatically switched over to 10K & 0.05% monthly upon raising $1M.
I'm not saying these solutions are necessarily good and I'm sure there's a dozen things I haven't taken into account. But these are all real problems I've seen that have caused real equity negotiations to fall apart.
It's a bad system that doesn't serve either side well and the only reason it hasn't blown up into a real issue is because cash is cheap enough right now that most of the deals I'm seeing amount to something like "within 20% of market wage + an insultingly small amount of equity".
I have no pretensions that the ideas I have are any good, feasible or even legal but I think it's at least worthwhile thinking and experimenting with models that serve the needs of both sides better.
Problem: Options are basically impossible to price (and are undervalued). If it costs me as an employer $100K to offer an options package but the employee only perceives it to be worth $10K, then it becomes a major problem using it as a hiring incentive. The problem is that standard option contracts are basically impossible to price. I like to think I'm relatively sophisticated at finance and I've worked through the options packages of a bunch of my friends and I always end up throwing my hands up in the air and declaring that I have no idea how to even approximate a fair price.
What most people far less sophisticated (aka most engineers) do is price on the underlying asset. eg: 4% of a company worth 1M vesting over 4 years equals $4000 of forgone salary (aka: not that exciting). In reality, basic options theory states that an option is always worth more than the underlying asset and the difference is directly dependent on the volatility of the underlying asset. On the flip side, liquidation preferences, dilution, acquihiring and the like drastically depress the value of an option. These two combined make pricing options a black art.
Solution: Think about it, nowhere else in the startup world do we make locked in 4 year contracts, why would you do it with employees? Would you sign a 4 year office lease? Would you commit to a fixed bill for EC2 4 years down the road? Startups are all about paying a premium for flexibility, I'd much rather offer 2% vesting over 1 year than 4% vesting over 4 and I wager employees would value it higher as well. Alternatively, get rid of linear vesting and implement something like 40%/30%/20%/10%. This at least makes refresher grants meaningful rather than a pitiful joke when put against existing options.
Problem: There are huge discontinuities in the standard vesting. At 1 year, your effective net worth suddenly takes a huge jump upwards and at 4 years, your effective salary takes a huge jump downwards (even accounting for refresher grants). These discontinuities are ruinous to employee loyalty. People are pretty lazy, they usually prefer a pretty good job to the effort of finding a better one. But 1 year cliffs and 4 year cliffs are just enough of a nudge to put people casually on the market.
Solution: Get rid of the 1 year cliff. The ostensible reason given for the cliff is that companies don't want to reward employees who don't work out. But you've already paid them a bunch of salary and spent the time hiring and training them!
If the concern is that you don't want them added to the shareholder limit, instead what might be a more elegant solution is that, anytime during the first year, if you leave for any reason, the company has the option to force you to sell back your shares for say, 2x the strike price. For example, say you're made an offer for 1000 shares per month at a $1 strike price and it ends up not working out in 4 months. The company has the option of either letting you keep 4000 shares or paying you $8000 to void the shares. This seems like a way better way to keep all the incentives aligned rather than blunt force cliffs.
Problem: It's easy to give people additional options but hard, and possibly illegal to take options away. On the surface, this seems like a win for employees. But like laws that make it harder to fire people, the perverse incentives make companies more conservative and make it worse for employees. A company that makes a mistake and offers a salary that is too high for an employee's value can at least attempt to re-negotiate and drop the salary. A company that makes a mistake on equity has no choice but to either live with it or fire the employee.
Solution: Making equity grants re-negotiable opens up a can of worms as Zynga discovered. Who knows? I don't have any great ideas about this.
Problem: Standard share grants are a shitty way to compensate for forgone income. Say you're a cash strapped startup and an engineer is willing to work for you as employee #1 for $12K instead of his usual 120K. How much is that worth in equity? It's hard to say since you don't know how long the income is forgone for. You could raise a Series A tomorrow and bump his salary back up to 100K, you could struggle to raise for a year while he gamely hangs on. Is that worth 1%? 4%? 15%? Who knows?
Solution: Agree on two vesting schedules that get switched over automatically upon hitting certain goals. eg: Agree to pay 1K & vest 1% for every month while bootstrapped which gets automatically switched over to 10K & 0.05% monthly upon raising $1M.
I'm not saying these solutions are necessarily good and I'm sure there's a dozen things I haven't taken into account. But these are all real problems I've seen that have caused real equity negotiations to fall apart.