By Thomas Hong
Most hi-tech startup companies incorporate a stock option plan for its co-founders and key employees. Many entrepreneurs do not understand the various parameters of a stock option plan. They often assume a lawyer will be able to implement an effective stock plan after the company is somewhat established. Sometimes this approach causes problems that are hard to fix and make acquiring employees, advisors, board members and investments more difficult as the company grows. This paper explains some practical stock option plan strategy to use for a typical hi-tech startup company.
Common vs Preferred Stocks
A common practice is for the company to authorize both common and preferred stocks in the stock plan. The preferred shares with liquidation preference are usually designated for investors and are priced higher than the common shares. The common shares are used for the co-founders, present and future employees, advisors and board members. The pricing for common and preferred shares should be established with the assistance of legal counsel. These prices will change over time as the value of the company changes.
Common Stock Option Plan
Common stock shares are usually allocated for these people: 1). Co-founders; 2). Present and future employees; 3). Advisors on Advisory Board; 4).Directors on the Board of Directors; and 5). Consultants
Co-founders. First time entrepreneurs sometimes assign a high percentage of the common shares (high percentage ownership of the company) to the co-founders and they are fully vested during the early stage. This is generally not a good strategy as potential investors view this approach negatively and often require re-structuring of the stock ownership before committing significant investment amounts. If a co-founder leaves the company significantly less than 4 years from inception due to voluntary or involuntary termination but owns all the vested stock; it is an unfair situation for the company and investors. A superior strategy for all the co-founders is to assign one portion of the common shares to the co-founders that are initially vested, a second portion to be vested linearly over time and a third portion to be granted for performance or milestone achievements. The total sum of all co-founder common shares is recommended to be in the 70% to 75% range. It should never be over 80% of the total common share pool.
Future Employees. If the total number of common shares is assumed to be 100%, than the portion allocated to both present and future employees should be 20% to 25% of the common share pool. Employees are usually granted stock options that are vested over 4 years with a cliff vesting of 25% after 12 months of employment. A superior strategy is to grant both a stock option that is vested over time and also award some common shares for specific achievements.
Advisors and Board Directors. It is recommended that the number of common shares reserved for Advisory Board members and Board of Directors be around 5% of the common share pool. Advisors generally receive smaller stock option than Board Directors who have more responsibility.
Preferred Shares for Investors
Principals of a company should not worry about their ownership as a percentage of the total stocks; common shares + preferred shares. Some entrepreneurs are reluctant to accept investment funds as they don’t want to dilute their ownership of the company. Most successful companies have fueled their growth with the use of investment funds and sometimes with the connections and advice of the investors. So even though the entrepreneurs have smaller ownership of a company due to dilution of the investments, if the company grows much faster and company valuation is much higher than their smaller ownership is worth much more. Thus this statement applies: “It is much better to own a small portion of a very large company than a huge portion of a small company.” Generally it is wise to accept investment funds at a modest valuation to grow a company rather than turn down investment funds because the investors will not offer the higher valuation the company principals seek. Entrepreneurs should seek outside professional opinion on company valuation.