Why Is Four The Magic Number?

No, this post isn't about achieving four wins in the NBA Playoffs.  It's about a historical anomaly in start-up compensation that I'm struggling with.  Although I know this risks being an unpopular post with entrepreneurs, I confess that I no longer get why we have four year vesting schedules for stock option grants at start-ups.  Let me explain.

Vesting is known as the time period during which you unconditionally own the stock options that are issued to you by your company.  Until you vest the stock options, you forfeit them if you were to leave the company.  Typically, that time period is four years.  There is typically a one year "cliff", which means that you don't vest for a year and then "catch up" by vesting 25% of the stock options on the one year anniversary.  Subsequent vesting happens monthly or quarterly, depending on the stock option plan your company has put in place.

I was explaining to a friend the typical vesting at venture capital firms is 8-10 years.  That is, if you leave a fund before 8-10 years from the start of the fund, you risk forfeiting some of your unvested profit interest in the fund, or carry.  I explained to my friend that this vesting schedule made sense given venture capital funds take 8-10 years from managing initial investments through to exits.

Then I realized that vesting at start-ups should also logically match the time it takes from inception to exit.  In looking at the data, it appears that the average time to exit in start-ups during the 1990s was 4-5 years, so the traditional 4 year vesting period made sense.  But since then, the average time to exit has creeped up meaningfully from 4-5 years to 6-8 years.  So why shouldn't vesting schedules reflect this reality?  Why shouldn't the vesting schedule for stock options be 6 years?  Boards are finding that they have to reissue options every 3-4 years because once an employee is fully vested, they naturally come back to the table with their hand outstretched asking for more incentive options to stick around.

In fact, why can't vesting schedules be flexible and simply a part of the overall compensation negotiation?  A CEO would benefit from having the tools at their disposal to adjust vesting dates alongside share amounts and other compensation levers.  In the very early days, you might have six year vesting on stock options.  After a few years, that date might be reduced to four or five, depending on the situation.  Some form of accelerated vesting upon change of control (i.e., a sale) is often a part of the package for senior executives, so if a quick exit were navigated, there wouldn't be a meaningful penalty.

So maybe you can explain it to me, but I just don't get why our industry clings to a historical magic figure of four years.

25 thoughts on “Why Is Four The Magic Number?

  1. Maybe in a private equity controlled firm for senior managers this could work. In a competitive job market for top performers, unless many pre-IPO companies start doing it, the companies that move to longer schedule will be at disadvantage. For many employees, four years is a long time and monthly vesting after the first year has more meaning.
    In addition, If these are stock options that can be exercised right away, then subject to vesting schedule on the purchased shares, then for employees that exercise them early, they are taking a bigger risk and putting money at stake. Extending the schedule is not needed. For more on this type of early exercise stock options, see the pre-IPO section on http://www.myStockOptions.com .

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  2. Employees aren’t in any way exempt from the 8yr exit timeline. They only cash in when the VC’s cash in, at exit. The vesting schedule is just a shorthand way of quoting the rate at which employees are paid equity.
    Even if you lower “equity wages” by extending the vesting schedule, you’ll still have the same problem that, in year 5, the employee can either (a) stay, and increase his now-smaller equity stake by 25%, or (b) leave, and vastly diversify his finances and his experience. The company needs to be on a tear to make (a) appealing.

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  3. The fundemantal difference is that the appropriate tenure for vp’s and director level execs in a start-up is only 3 to 4 years. This is due to the rapid change in complexity a company experiences from start-up to exit. Execs with different skill sets will be needed and hired as the company expands. The original execs will either have a different role, or will have left. Unlike venture capital firms, where partners are not replaced with more expereinced partners. The investing partner is expected to be the same partner at exit. There is no notion of a partner that has the skill set to diligence, close, nurture for a bit, then be replaced with one that has the skill set to expand and usher the comany through a trade sale or IPO. 3 to 4 year vesting still feels right for start-ups

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  4. TypePad HTML Email
    Interesting suggestion.  I’m a fan of
    restricted stock for the earliest folks to help them lock-in long-term capital gains
    tax, which is sort of related.
     

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  5. Here’s some more crazy talk 🙂
    Make many more employees in the startup feel (and actually be) founders by letting all of their options vest *immediately*.
    The purpose is to take the money (and stock) issues off the table in order to get more motivated and loyal employees ala Dan Pink’s thoughts on motivation.( see Brad Feld’s recent post & comments here : http://www.feld.com/wp/archives/2010/05/does-more-money-motivate-higher-performance.html) .
    Pick the the larger number of employees that will be founders based on some company specific criteria and planned exit strategy – maybe the first 20 employees.
    At least one reason this might work:
    If the startup runs in to hard times and can no longer pay employees it may be more successful at scaling back operations while keeping the larger group of founders motivated to continue building the company while it falls back into garage mode. They’re founders after all, their motivation is not stock as much as building a successful company.
    Cheers!

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  6. This raises the real issue of should VC equity and Employee equity be completly aligned. If the answer is yes than you have to put senority of the security, dilution and a host of other issues on the table.

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  7. TypePad HTML Email
    Employees get paid salaries to deliver
    results and cash or stock bonuses help focus on milestones.  Stock options are
    really about earning into equity ownership over time.  That equity value is
    only really realized at exit.
     

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  8. I did not read all the comments, but, as a conceptual matter, shouldn’t vesting be tied to the “deliverable” of the particular employee rather than the ultimate deliverable of all employees in the aggregate (i.e. and exit). Take and easy example (and I admit not every example is easy), I need to get my beta out the door in 12 months. Why not vest my coders on the milestone of getting beta out the door? If I fire everyone of them after they deliver beta and hire all new people, they earned their keep. What does the exit have to do with it?

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  9. TypePad HTML Email
    Good points.  I think this plays into my
    point about flexibility – if you’re a founder who is the “starter” founder, you
    can argue for 2-3 year vesting.  If you aspire to be an “end to end” founder,
    you should have longer vesting.  By not having any variability in the vesting schedule,
    we are missing the opportunity for clarify on alignment.
     

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  10. I think it’s important that the entrepreneur be on the same side of the table as the investor with respect to future needs for their own replacement. That may mean that they’ve made an important contribution to the business in the first couple of years, but might need to plan for their own obsolescence. Shouldn’t this be reflected in a shorter vesting schedule, and if so, be better than motivating the founder/CEOs from trying to entrench and make themselves irreplaceable? I would think the entrepreneur should be focused on adding maximum value, yet also making themselves dispensible (as every member of a team should be, in my opinion; team > individual). Founders should be focused on maximizing their contribution and enterprise value, not institutionalizing their role.

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  11. TypePad HTML Email
    Most boards/investors typically don’t like
    to do 100% acceleration on a “single trigger” (an acquisition) because it’s a
    turn off for the acquirers but executives will often get 100% or 50% on a “double
    trigger” (first trigger: acquisition; second trigger:  fired or asked to move).
     

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  12. jeff, awesome thought-provoking post on vesting schedule. what are your thoughts on accelerated vesting? as someone who led a couple of startups to exits, and is now a GP at a VC fund, would love to hear your thoughts.

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  13. I think on the contrary, we should encourage shorter vesting periods, and make it more commonplace to issue new shares as needed.
    * Incentivize new talent; there’s too much entitlement to early employees, some who are often mediocre… they deserve reward for their risk, but only to the point that’s commiserate with their value added.
    * Keep the overall ecosystem nimble with a healthy 3 or 4-year turnover – if it’s worth staying around, they will… if it’s not, set them free.
    * Talented employees should get new shares every year as a bonus/incentive than wait out 4 yrs and see where they are, waiting on broken promises… maybe annual issuance with 2 yr vesting.
    * The system is flexible – any stakeholder can have their % fully preserved at every issuance of new shares.
    Maybe it’s naive to think shares can be so easily created (legal and financial overhead) – but maybe that’s what needs correcting?

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  14. One good regulating mechanism that already is baked in is the risk of dilution if it takes longer/more capital to reach an exit, or the company hits some bumps on the road. In the case of significant dilution, those still with the venture generally get a “refresh” with a brand new vesting schedule.
    Conversely, in the “up, up and away” case, few will begrudge the founders their early vesting.

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  15. Interesting thoughts and arguments for a chance to the schedule.
    Of course, the best way to properly align incentives would be to allow boards to have more flexibility to alter schedules if that would be supported by practice and custom.
    However, the problem with greater flexibility is that you will quickly start to have 409A issues that you don’t have when you have a set plan. Not to say that you couldn’t structure things in a way to avoid 409A, but it is certainly something that will muck up any attempt to bring more flexibility to the system.

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  16. Two questions come to mind. One, is vesting schedule meaningful enough to spend time and effort negotiating it instead of or in addition to other terms? Two, does opening it up make a VC less competitive in getting deals done? My best guess is that the answers are no and yes, which would explain why no one really bothers with this.

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  17. TypePad HTML Email
    All very good points, Michael.  Yes, I think
    you’d need to have larger option grants to elongate the vesting.  I think
    founders are there for the long haul, so I do expect them to stick around 5, 6
    even 7 years if that’s what it takes to create value and see it through.  I had
    one investor/board member tell me in a reference call about a CEO/founder that
    he was annoyed that, despite navigating a 10x exit, he had left just before the
    1 year escrow was released.  Investors want entrepreneurs to be stewards of
    their capital from end to end!
     

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  18. You raise some good points…but I think you’ll find that the type of person you attract to a risky startup has a shorter attention span than the 6 years you suggest.
    For rank-and-file, as much as you want to tie the compensation timeframe to your (owner’s) liquidity schedule, you’ll also need to consider the employee’s perspective, where the type of person who thrives in the startup world probably looks at the engagement as a 3-4 year one at most.
    For executives, who you want to have a meaningful amount of compensation tied to liquidity timing and value, the argument may make more sense…except that you also have to recongize that another reason why “boards are finding that they have to reissue options every 3-4 years” is that the initial grants are diluted through additional investments and thus much less meaningful by the time they are fully vested. And at the same time…as much as you suggest (probably correctly) that the average time-to-liquidity has lengthened to 6 years – has the average executive tenure been extended as well?
    And I assume that if you are proposing increasing the vesting schedule by 50%, you are also proposing to increase the percentage by 50% as well? Or are you just suggesting a reduction in compensation through a lengthening of the schedule?

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  19. A few questions related to that:
    1) If you increase the time, does that inherently mean you need to increase the equity offered? You’re talking about a 50% (or more) increase in time required to be at the company.
    2) Is every early stage employee really suited for the later stages of a growth venture? Are you better suited having some of those scrappy, “athlete” early stage employees moving on before Year 8 anyways?
    3) What would happen to non-founding employees after an early acquisition? If a company was bought in 4 years, would you be tied to the acquiring company (which would likely be a totally new environment, potentially in another city) for 4 more years?
    4) If you’re at a venture for a full 8 years, doesn’t additional equity later make sense given the dilution the employee may have very well faced during subsequent investment rounds?
    All of this still leaves the question of “why 4?” It seems like maybe it’s just one of those numbers that just became a standard because it was a compromise between short and long term.

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  20. If a company went with a 6-8 year vesting schedule, what would happen to non-founders in the event of an early exit? For instance, if I join a startup and it gets acquired in two years, am I now expected to work for the parent company for 4-6 more years in order to fully vest? Is acceleration typical for non-founders in these circumstances? (Or philosophically speaking, should it be)?

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  21. I agree, why does it have to be four ! I think you cover the issues around four or MORE years. But there’s also a STRONG argument for doing shorter total vesting intervals.
    Seems to me the average tenure of a lot of executives at startups, particularly CEO’s seems to be less than 4 years. Why ? Because early stage companies move through maturation stages sometimes VERY FAST. It’s unusual to find people to staff key areas in the company that have skillsets and experience that span a 4 year interval from inception to, say, $30 million or more.
    The rub (and major headache for a VC) seems to be when someone (the founder or other key member) runs past their maximum contribution point. Then there’s always a big discussion around “what do we do with the options”.
    Why not address that up front. For example, the FIRST CEO will probably be there 12 to 24 months. Make a package that vests over that period and ASSUME all around the table that if the company is having any kind of success there will be a new era of management and staff. Shouldn’t the original team be able to support and take full advantage of the change ? Seems to me this is the way it really goes anyway.

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