Are share options bust?

With startup companies the model for getting early employer buy in is to offer share options. The formula is typically as follows:

An amount of share options is put aside, and every year a percentage of those share options are given to the employee, up until some cut off point after which all the share options have been granted (the ‘vesting period’). That period is almost always 4 years.

This is a very long standing arrangement in Silicon Valley, and has been exported to other parts of the globe. But the startup world has been changing over time, which makes this model void.

The purpose of share options is to allow employees to buy shares at a pre-determined price, and in the likelihood of a company sale or flotation (the ‘liquidity event’) to sell those same shares at a higher price. Sounds great, except the time from company inception to a liquidity event has been steadily getting longer.

This quote is from the April issue of Wired US:

In 1985 most VC-backed companies were less than four years old at the time of their IPOs. By 2009 most of them were more than 10 years old.

So the vesting period of 4 years matched the typical time to flotation of a company, back in the 1980s.

But for a modern firm the early employees are unlikely to ever see a flotation unless they stick around for 10 years. The major winners will be people enticed into middle management around 5 to 6 years in with generous share option packages.

This is one reason why share options make no sense. Under this system there is no encouragement for early employees. Of course the converse could be true, where early employees are given too many share options, and later employees who have put in long service feel unfairly compensated.

Also, share options are one of those dangerous things in management - they put a number to someone’s value. Just as an employee will be annoyed if another employee earns more for a seemingly similar role, the exact same is true of share options.

So what solutions are there?

Secondary markets (such as SecondMarket and SharesPost) allow employees to sell shares at a given date to private investors, which is a substitute for a liquidity event far in the future. This sort of activity will likely become more popular.

Or alternatively, just scrap share options all together and replace it with another system as 37signals have done.

Perhaps lessons can be learned from successful cooperatives like John Lewis where every employee is a share holder and receives a share of annual profits.

But one thing is for sure - something simpler, and more in touch with the times is needed.

Further reading

  • A great explanation of the perils and politics of share options.