The Failures of Traditional
Employee Stock Options

Time to Admit that Employee Stock Options May Not Serve Their Primary Purpose

It may sound ridiculous, but there are legal trends which do not differ significantly from the trends in the “outside” world, like fashion or cinema. Regardless of the industry, people do things without pondering the purpose too much, simply because other people do them in that particular way too. Trends usually change fast, but the majority of lawyers are, at the same time, quite conservative, and it takes them some time to adjust to a new business reality.

I cannot tell you how many times I have heard, either during financing rounds or incorporations, the same mantra statement – “the company needs an Employee Stock Ownership Plan (ESOP) and we want to start issuing option grants immediately after the closing”. Typically, 10% of  outstanding common stock is authorized for the ESOP, stock options are granted, and everybody continues with their daily business. That is, of course, until they figure out what they have signed up for, and start wasting time dealing with issues stemming from the mismatch between everybody’s expectations and what a traditional ESOP actually entails.

Below I will point out some of the weaknesses of traditional ESOPs. For reasons that will be made obvious, the analysis is applicable only to closed corporations, especially in their early to middle stage of development. I do not want to discourage anybody from using traditional ESOPs, as they have proven to be an important part of incentivizing employees. However, I hope that after reading this article you will double check if what you need, and your employees want, is actually a traditional ESOP.

A Quick, Basic Refresher on ESOP and Stock Options

A traditional ESOP is basically a pool of shares of common stock reserved by the company to be issued to employees, consultants and advisors of the company as an incentive or reward. The ESOP shares may be granted straightaway as Restricted Stock Units (RSUs) or as stock options. The latter are much more prevalent, and thus I will focus on them. Stock options provide employees with an opportunity to buy a certain number of shares for a certain period, at the strike price, which remains unchanged regardless of the future valuations of the company’s stock. Only once the option is exercised does the option holder pay the strike price and become a shareholder.

The general usefulness of stock options cannot be questioned. They ensure alignment of interests, and make employees to feel part of the company. This is especially important to attract millennials who have proven to be less motivated by “dull” monthly remuneration. It is also a great way to preserve liquidity for bootstrapping companies. Unfortunately, there are certain problems which cast a shadow of doubt over the optimality of traditional stock options.

The Case Against Traditional Employee Stock Options

1. Hoping for the Exit

The first problem stems from the fact that employees are in fact restricted as to when they can exercise their options, and when that moment comes their backs are against the wall.

Stock options can theoretically be exercised immediately upon being granted, or later on, in accordance with their vesting schedule. Of course, exercising options as soon as they are granted is not viable, as the strike price equals the fair market value as of that moment, and there is no financial benefit in exercising the option at that point. A stock option can also be exercised afterwards, gradually, upon learning that the fair market value of the company stock has increased. This is also not a realistic expectation – firstly, given that shares in a closed corporation have no liquidity at that point; secondly, the fair market value of a closed-corporation stock is a very flimsy concept in the startup world. Even mandatory 409a valuation opinions are not really reflective of a company’s actual financial situation, given that they are heavily influenced by financing rounds, where valuations can be absurdly high or low. Therefore, it is no surprise that the employee does not want to pay for stock that can as well take a nosedive within a month.

For these reasons employees are almost always aiming for the exit (aka liquidity event). Frankly speaking, who can blame them? Why would they spend money on stock in a company which doesn’t pay dividends, they don’t really know much about, is illiquid, could just as easily plummet in value next month, and is, by very nature of startups, unlikely to succeed anyway. Not to even mention the tax consequences of exercising the option.

Everybody keeps waiting for the exit. Unfortunately, the truth is that a significant proportion of employees will leave or be fired beforehand. This is when the loyal (i.e. vested) ones discover that the carrot they have been working for must be consumed in one bite, and it must be done now, or otherwise it’s gone.

2. Unrealistic Time Window to Exercise the Option After Employment Termination

According to standard ESOP provisions, employees can exercise their options within 90 days of termination of employment. Payment is due immediately upon exercising the option. The reality is that employees, especially in early to middle stage startups, cannot be expected to muster the necessary funds at the moment their employment terminates, especially in the U.S. where at-will employment is prevalent and the employee’s source of income may abruptly dry up, forcing him or her to forfeit the opportunity to exercise.

Again, some will be triggered by this, but in early to middle stage startups exercising options is still as good as gambling. Why would they dedicate significant funds without real knowledge of the company’s performance, and buy illiquid, non-transferable stock, plus get hit with extra tax on top of that. In theory, this may be solved by the company by either granting a loan to the employee or extending the time window for the exercise of the option, both entailing further problems of their own.

All in all, in my opinion, it is hard to deny that this setting is not optimal. Stock options often compensate low salaries with the purpose of incentivizing employees and benefiting them financially. Stock options should invest employees in the company’s success, not impose the burden of saving cash for the exercise of the options.

3. Stock Options Mess Up the Cap Table

Another issue I have with traditional ESOPs is the pointless dilution of common stockholders (i.e. mainly founders). Upon exercise of an option it is the common stockholders who take the hit and have their ownership diluted. At the same time, a passive plankton is created, with no meaningful say in the company’s affairs. However, it still comprises stockholders who have certain information rights and need to be kept in the loop with regards to decisions of stockholder majority, which practice shows to be an idea worth serious consideration. It should also be considered that such an employee, upon becoming disgruntled, can fire a derivative lawsuit against the company as a shareholder.

The exercise of options is also undesirable from the company’s standpoint, as it would impose the administrative burden of issuing certificates or notices of issuance to the new shareholder and adjusting the cap table. Finally I am frankly not sure if traditional ownership of equity is really what employees desire while stock options are being discussed and offered.

4. Securities Law Limitations

Issuance of stock options under ESOP constitutes a sale of securities, and thus has to be performed based on one of the exemptions available. The most common exemption used for the purpose of ESOP is Rule 701 of the Securities Act of 1933. Rule 701 provides that the exemption is available only if the amount of securities that may be sold during any consecutive 12-month period in reliance does not exceed whichever is greater: $1,000,000; 15% of total assets of the company; or 15% of the entire class outstanding. This is not rocket science, but it means that issuing grants requires additional oversight, given that issuing securities without properly relying on an available exemption has grave consequences.

Summary

In summary, stock options are a great tool, but do not necessarily fit the needs and expectations of an early to middle stage startup. Unfortunately, all advantages aside, it effectively forces employees to make a choice to invest their hard-earned funds in a non-transferrable, illiquid stock of a closed corporation which, in case of startups, is either going to scale fast and reach an exit or, more likely, fail. The options an employee has in a termination scenario are limited, and he often ends up at the company’s mercy. Finally, it may be detrimental to the company’s interests to distort the cap table by introducing employee plankton who are disinterested in the company yet need to be treated as a common shareholder with all the associated administrative burdens and compliance obligations.

So Now What? An Alternative

Please stay tuned for the next article where I will analyze a viable and, more importantly,  existing and battle-tested alternative – Virtual Stock Option Plans – which alleviate at least some of the problems associated with traditional ESOPs.