Why are U.S. VCs ready to provide up to 30% of the equity of a company in stock options to employees ?
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U.S. investors are ready to take risks on technology or on markets, but not on the management team. The first question a VC asks will be: "What is the level of involvement of the management team?" The VC will be concerned if the management team running the business does not own a significant equity stake. The typical mechanism for management equity compensation is a stock option plan. The reasons are easy to understand:
- Employees Have an Equity Upside. Stock options have an
exercise price, which is the price paid to exercise the
option and buy the shares of stock, and the shares of stock
acquired upon exercise have a selling price. If the price
goes up between buying and selling, the employee makes a
profit. So-called "incentive stock options," which receive
favorable tax treatment under Federal U.S. tax laws, do
not bear Federal income tax upon exercise of the options.
Thus, employees do not have to pay income taxes on the stock
acquired on exercise before selling those shares. The exercise
price is defined by the board of directors of the company,
and the price is generally the fair value of the shares
when an employee joins the company. Typically, the earlier
you join, the less expensive the options. Options "vest,"
meaning that they become exercisable, over time. Typical
vesting periods are three or four years, with some options
vesting each month or year. The employees cannot exercise
the options until they vest. After they vest, the options
become exercisable. Stock options are thus a type of asset
without up-front cash.
- Employees Stay with Companies if they have Options. If
an employee leaves the company, they will be allowed to
exercise only that part of their stock options that have vested,
and they will have to pay for the vested stock options within
a short period of time after leaving the company, or the
options will lapse. The more stock options an employee owns,
the more cash they need to pay for their stock options in
case they want to leave before the company becomes public.
If the employee cannot pay for them, they lose their stock
options. It's a strong reason not to give up! When the company
goes public (or after being bought by a public company),
the employee can sell their stock more easily. Therefore, most employees
wait until a company goes public or is sold before exercising
the options and paying the exercise price.
- Employees Are Not Stockholders Until They Exercise Options. VCs do not like to deal with too many stockholders who may slow down the investment and shareholder approval process. Employees with stock options are not stockholders. They do not have to vote and be a part of stockholder meetings. Employee wealth is tied closely to the success of the company, and employees tend to stay when they own significant stock options. VCs are willing to give up equity to hire the best managers to run the business they have invested in, and to keep them over the long run.
By John Pomerance, Attorney at Law If you have questions, please e-mail John