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Is there a problem with options?
This is part six of a series on ownership for founders. This isn’t a series on how to raise, but how to understand different owner perspectives, including your own.
One of the core beliefs in startups is the value of stock options for incentivizing employees and sharing in the upside.
Options are how startups say “we’re all in this together.”
Carta recently released its State of startup compensation, H1 2023 with data from 40,000 startups.
Founders should read this report (and the equity Addendum). It’s a data-driven way to check some of the conventions and rules of thumb around the ESOP.
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Size of the ESOP
At the Seed or Series A the ESOP, post-investment, is typically 10-15% of equity, fully diluted.
Two early stage VCs I spoke to both said they target an ESOP of 10%:
“Assuming a normal cap table, we push for 10% post investment.
The reason is that we want them to have a robust ‘budget’ of options including buffer to give out to future execs and team members or to top up the founders.
The reason for buffer is to have a margin of error/flexibility but also because we are not diluted by the initial ESOP top up vs. future top ups.”
“Generally speaking we like to see a top up of the ESOP to about 10% post funding. The amount is based on what the board and management think is needed to incentivize the existing and new employees to hit the next meaningful milestones.”
According to Carta, the median early stage ESOP is 12.9%.
I do not have access to the underlying data but this might be saying that founders assume the ESOP should be higher, eg 15%, while VCs expect 10%. If this is the case founders should stop doing that because, as Isaac pointed out, the initial ESOP dilutes founders only.
Keep in mind we are talking about the total size of the pool whether those options have been allocated/exercised or not.
Equity for early employees
Speaking of actual option allocations, the median equity granted the first 10 employees totalled 4%. Even accounting for ‘buffer’ this seems low.
The rule of thumb I’ve heard is “10% for the first 10 employees.” These data say founders are not following that convention.
It’s true that equity grants have fallen by 26% in the first half of 2023 (fewer hires, more negotiating power for companies).
But I think founders are creating too much buffer with a larger ESOP pool paired with lower grants.
That doesn’t make sense when you consider the next section.
By the end of August 2023 only 28% of vested options were exercised before they expired. The downward trend reflects overall sentiment about startups over the last 2 years. But even looking at the five years of data provided, the majority of vested options are never exercised.
This is important for founders to think about:
The initial ESOP is too big
Early employees are not being given enough equity
The majority do not exercise their options
Again, this is way too much buffer and it means startups are not fully utilizing an important incentive when they need it the most.
Why is this happening?
The easy answer? Employees in startups do not value ownership as much as founders would like to think. They do not want options to be used to reduce their base salary. They see their equity as more of a lottery ticket based on chance and not something they can control.
Challenge for founders: run an anonymous survey of your employees and ask how much they value the equity you’ve given them.
The harder answer is this: there’s a gap in perception about the value of options and founders themselves are contributing to it.
First, the data says founders are keeping too big a buffer of unused options. That benefits them since in an exit unvested and unexercised options are discarded. But that’s short-sighted because the value of equity should be the growth it drives by incentivizing the team.
The dilution of the ESOP is over stated considering how few options are ever exercised. So founders should spend it. Hoarding is only one way to say those options are valuable. Another is to spend it on your best people.
The other thing founders can do better is to educate their team about how the cap table works so they understand how options grow and become valuable. Don’t assume early employees understand how startups work.
I know some founders admit to not fully understanding cap tables themselves. I’m trying to help with that.
It should be part of employee onboarding to spend time learning about how cap tables work, why it’s valuable to them and, most importantly, how their contributions are meaningful.