Editor’s note: Jim Verdonik and Benji Jones are the cofounders of Innovate Capital Law in Raleigh and are regular contributors to WRAL TechWire.
RALEIGH – Founders compensation for start-ups is always the same whatever the economic conditions are. For the first few years founders can expect:
- Little or salary
- No bonuses
- No benefit plans
- Long hours
- Negative cash flow draining bank accounts
If that sounds attractive, CONGRATS – you are an entrepreneur!
We might say that founders catch up from this slow start, because their business increases in value over time. But that’s only partially true. Most of the value increase in any business is realized when the business is sold. Until then, recognized value (the kind you can spend) usually increases very slowly. So, the best time to get a big boost in value is to join a good start-up a year or two before the business is sold. That’s when you acquisition price is still low, the business can pay you a salary and the exit event is relatively close.
This fact of life in startups benefits management and technical talent that are important to growing the company after the startup period and hurts founders and early investors.
These are the best of times for people whose experience is in demand.
Compensation for experienced tech executives who are willing to join start-ups as they grow change with the economic climate. The US economy is experiencing full employment – that means that everyone who wants a job already has one. So, people with good experience leave their current jobs for one thing – a better job with higher compensation.
Big companies and startups are competing for the same talent pool. As big companies increase salaries, it’s harder for startups to attract the talent they need to grow.
How are start-ups responding to the talent bidding wars?
Its difficult for start-us to compete with big companies dollar for dollar in salary, bonuses and benefits. Even in good economic times, start-ups must manage cash flow very closely. The one area where they have greater flexibility to pay cash is in sales commissions and bonuses. These days salespeople who increase revenue are getting higher commissions and bonuses, but it’s more difficult for start-ups to increase cash compensation for employees outside the sales force.
What start-ups have going fpr them is that they can print equity to recruit and retain management teams and technical people. So, the biggest changes in compensation are in the equity compensation arena.
This translates into more shares being granted to management teams. Yay for them!
But increasing equity compensation for new recruits dilutes founders and the investors who sit on Boards of Directors. Often, there is resistance at the Board level. So, businesses look for other ways to increase the overall value to employees of equity compensation packages that results in lower immediate dilution to existing owners.
A look at equity enhancement
These equity value enhancement tools include:
- Vesting Schedule Length. Vesting schedules vary, but most are in the range of three to five years with four years being the market average over time and across industries. These days, management talent is often negotiating three-year vesting. After three years, the employee can either negotiate for more equity from his current employer or leave and get equity from another employer. Often, leaving makes sense from the point of view of asset diversification. Equity compensation often constitutes a big percentage of an employee’s net worth, but owning the stock of a single private company is risky – the business of that company could deteriorate quickly. Employees are wise to diversify their sweat equity portfolios the way investors do. Employees reduce risk if they own the stock of two, three or even four employers rather than one company, which they can do if the change jobs every two to three years. One pitfall is that stock options often provide that they terminate if the option is not exercised within 90 days after employment terminates. Sometimes the employee lacks the money to exercise the option or the option exercise is a taxable event and the employee can’t sell the stock to pay taxes. We have advised several employees in this situation during the last year.
- Cliffs. A “cliff” is a period of time during which no vesting occurs. Often, the vesting schedule provides that no equity is earned if the employee leaves or is terminated during the first year. After the first year, vesting might occur monthly or quarterly. Currently, cliff provisions are on the decline. In-demand employees are getting monthly vesting from the start. One reason is that they may be leaving companies where they are already vesting each month. So, agreeing to a cliff would be a step backwards.
- Accelerated Vesting. Investors and founders get a big payday when the business is sold or goes public. Employees want the same payday. They can get that if their shares immediately vest when the company is sold or does an IPO. Accelerated vesting comes in many flavors. Vesting can be full or partial. Double trigger requires both the company sale to occur and the employee being fired within a defined period of time after the sale. Single trigger accelerated vesting means the acceleration occurs even if the employee is not fired. These days, more employees are getting single trigger accelerated vesting. That is often a double bonus, because it often means the company that buys the business has to give more equity grants to retain the employee after the purchase closes.
- Types of Securities. Stock options and restricted stock are still the most common types of equity compensation, but some start-us have switched to Restricted Stock Units. Employees benefit, because there is no upfront purchase price like with restricted stock and no exercise price like with a stock option. The Restricted Stock Units are never “out of the money,” which means that is always has some value if the company stays in business. Tax treatment of RSUs, however, discourages many companies from making this change.
These changes in equity compensation practices can impact deal terms and ability to raise capital.
For example, we are working on a deal now where an investor backed out because the percentage of the equity the management team had was too small. Prior investors retained too much of the equity. The new investor worried that the management team would be lured away by better compensation packages that competitors are offering.
Single trigger accelerated vesting may hurt founders and investors, because a buyer who has make a lot of new equity grants to retain employees often reduces the purchase price by the value of the new equity grants.
Finally, smart employees are asking questions about how the company’s capital structure affects the value of their equity compensation. Companies that have issued a lot of Preferred Stock or convertible debt to investors are facing difficulties attracting employees with equity compensation, because the liquidation preferences of the investors make the common stock less valuable – sometimes worthless. A company that has raised a lot of capital with liquidation preferences could be sold for thirty million dollars or more with all the sale proceeds going to investors in the form of liquidation preferences. If a tight labor market persists for an extended time, investors in businesses that have a lot of liquidation preferences may be forced to give up some of these preferences to make equity compensation an effective tool for attracting and retaining employees. Expect to see more of these “reverse cramdowns” occurring in companies that have raised a lot of money. The prospect of such cramdowns or not being able to attract new talent may cause investors to accelerate the sale of the some businesses.
Most of our clients use some form of equity compensation. It’s an important tool for growing businesses that can’t pay top salaries. We can tell you that a lot of time is spent at board meetings these days trying to devise strategies to recruit new talent at the lowest dilution to founders and investors, but these days talent is in the drivers seat.
That’s our view of the current start-up compensation trends. Of course, in the start-up world things change quickly. Right now, new talent has the bargaining leverage. A recession might change that.
Contact us at:
Jim Verdonik, 919-616-3225; JimV@InnovateCapitalLaw.com
Benji Jones, 919-673-4301; Benji@InnovateCapitalLaw.com