Andy Rachleff is President and CEO of Wealthfront,
a software-based financial advisor. Prior to Wealthfront, Rachleff
co-founded and was general partner of Benchmark Capital. He also teaches
courses on technology entrepreneurship at Stanford Graduate School of
Business. Follow him on Twitter @arachleff.
“The defining difference between Silicon Valley companies
and almost every other industry in the U.S. is the virtually universal
practice among tech companies of distributing meaningful equity (usually
in the form of stock options) to ordinary employees. Before companies
like Fairchild and Hewlett-Packard began the practice fifty years ago,
distributing stock options to anyone other than top management was
virtually unheard of. But the engineering tradition that spawned Silicon
Valley was much more egalitarian than traditional corporate culture.”
The equity culture among young technology companies is
almost universal. When implemented properly, broad employee ownership
within a company can:
- Align the risk and reward of employees betting on an unproven company.
- Reward long-term value creation and thinking by employees.
- Encourage employees to think about the company’s holistic success.
Unfortunately, despite decades of experience building new
hire option plans, many startups still fail to put in place an equity
compensation plan that adequately rewards long term employees over time.
When I was a venture capitalist, I noticed companies that
seldom lost employees due to recruitment had a lot in common. Sure they
offered challenging and inspiring work environments sought by top-tier
talent. But you might be surprised to learn they all rewarded
outstanding performance through the issuance of additional stock options
(or as is now the case, RSUs) in a similar way.
The Wealthfront Equity Plan
Based on my observations, I created an equity allocation
plan that I encouraged all my portfolios to adopt. It worked so well
that executives and my fellow board members usually brought my plan with
them when they got involved with other companies. Over the years, I am
proud to say that hundreds of companies, including Equinix, Juniper Networks and Opsware, adopted this plan because it just made sense.
Not surprisingly, we’ve put this plan in place at Wealthfront.
How It Works
The Wealthfront Equity Plan is designed to specifically
handle the four most important cases for granting equity to employees.
Each year, you create a new option pool that addresses the following
needs:
- New Hires: These grants are used to hire new employees at market levels.
- Promotion: These grants are intended to reward employees who have been promoted. Promotion grants should bring the recipient up to the level you would hire her at today for her new position.
- Outstanding Performance: These grants, made once each year, are only intended for your top 10% to 20% of employees who truly distinguished themselves on the basis of amazing accomplishments over the past year. Individual performance grants should represent 50% of what you would hire that person at for their position today. This pool should be reserved for non-executives.
- Evergreen: These grants, which are appropriate for all employees, start at an employee’s 2½-year anniversary and continue every year thereafter. The idea is you don’t want to wait until the employee’s initial grant has been fully vested to give a new grant because by that time the employee will evaluate new opportunities. Annual evergreen grants should equal 25% of what that employee would receive if she were hired for her same position today. Giving 25% of the market rate for a position each year, rather than a lump sum grant that covers the next four years, will smooth out the vesting process so the employee never reaches a cliff. As I said before, cliffs cause people to raise their heads to consider alternatives and should be avoided at all costs.
The Key: Consistent, Early Evergreen Grants
Most companies put considerable effort into the size of
their equity grants for new hires. It’s rare these days to find new
hires that haven’t used a tool, like the Wealthfront Start-Up Salary & Equity Compensation Tool, to determine the appropriate amount of salary & equity to expect for a given position.
Fewer companies, especially young ones, put significant
effort into thinking about follow-on grants. If you tell your employees
to “think like an owner,” then you need to consistently align equity
with their contribution to the success of the company.
Evergreen grants are the most common area where technology startups fail to invest time until far too late in their development.
“The average tenure for most technology employees is two to three years, and waiting until your first employees hit year four is just too late.”
Instead
of an ad-hoc process, the Wealthfront Equity Plan offers a transparent,
consistent and fair program of equity grants that employees can build
into their long-term expectations. As a result, not only do you avoid
cliffs, but you also tie both long-term tenure and contribution to their
ownership stake. The best part is that, as your company grows, you
always grant stock in proportion to what is fair today rather than in proportion to their original grant.
What About Dilution?
Based on our calculations, the Wealthfront Equity Plan
should result in approximately 3.5% to 5% annual dilution assuming no
executives need to be hired. (Please see our Slideshare presentation
for the details of how to allocate stock for a 50-person private
company). As a point of reference, most public technology companies
increase their option pools by 4% to 5% per year, so the proposed
dilution is well within the reasonable range.
The Wealthfront Equity Plan might result in 0.5% to 1%
extra annual dilution relative to less generous plans. One way to think
about the trade-off is to ask yourself, if you’re a stockholder, would
you rather be assured of retaining a much higher percentage of your key
employees and own 97% of what you would have owned without the
Wealthfront plan over your four-year vesting period (4x the mid-point of
0.5% to 1%), or deal with the risk of losing valued team members and
not suffer the additional dilution? I would take the extra dilution 11
times out of 10.
That being said, there are a number of board directors who
think that is too much dilution for a company to absorb. A few months
ago, a fellow I recruited as CEO to two of my Benchmark portfolio
companies told me he never appreciated the value of the Wealthfront
Equity Plan until he joined a board where the board members were too
cheap to do the right thing for their employees. Needless to say, he
implemented the Wealthfront Equity Plan when he started his own company.
Investors and employees make much more money by increasing
the size of the pie rather than their share of the pie. The only reason
not to implement the Wealthfront Equity Plan is greed, and greed seldom
leads to a good outcome.
An Equity Plan that Works for Employers & Employees
One final observation about companies that successfully
retain employees: They usually create a culture that treats options as
something dear that aren't offered as an alternative to a cash bonus.
They encourage employees to think about increasing the value of their
options through accomplishment rather than asking for more upon
completion of a task. It has been my experience that companies granting
options for completion of milestones seldom build a culture that values
equity — and therefore suffer greater turnover.
A well-designed equity allocation plan works for both the
employer and the employees. The Wealthfront Equity Plan creates a
tremendous incentive for people to stay at a company without costing the
employer too much. That’s the kind of win-win to which we should all
aspire.
Read more: http://firstround.com/article/The-Right-Way-to-Grant-Equity-to-Your-Employees#ixzz2qJ7BLaAA
