Episode 58

full
Published on:

31st Oct 2024

58. Decoding Option Grants

In this episode we discuss: Executive compensation and option grants. We are joined by Daniel Harris, Exec Compensation Partner.

Love The Operations Room? Please support us by rating and reviewing it here.

We chat about the following with Daniel Harris: 

  • What to consider when negotiating equity packages.
  • What are the different equity schemes, such as sweet equity, and their implications?
  • When to be aware of with tax implications and when to seek expert advice.
  • Paying attention to strike prices and their impact on the value of equity.
  • How to align incentives and interests between founders, management teams, and employees.
  • Is it possible to ensure alignment between company strategy and compensation structure?

References 

  • www.linkedin.com/in/daniel-harris-a7333511
  • www.pwc.com

Biography 

I lead the Reward team in the Regions and have over 20 years’ experience of advising companies (both public and private/ private equity backed) and their remuneration committees on all aspects of executive compensation, including the design and implementation of tax efficient and commercially effective pay structures and management incentive plans in the UK and overseas.

To learn more about Beth and Brandon or to find out about sponsorship opportunities click here

Summary

13:56 Introduction and Relevance of the Topic

02:43 Exploring Different Equity Schemes

24:33 Equity Structures in Different Stages of a Company's Lifecycle

26:47 Considerations for US Taxpayers in Negotiating Equity Packages

30:56 Key Elements of a Good Equity Package

34:13 Changes in Strike Prices and EMI Scheme in the UK

36:16 Balancing Performance-Based Vesting

39:45 The Benefits of Accelerated Vesting

41:00 Understanding the Differences in Equity Compensation Systems

41:57 Main Takeaways



This podcast uses the following third-party services for analysis:

Chartable - https://chartable.com/privacy
Transcript

Brandon 0:05

Music. Hello and welcome to another episode of the operations room. I am Brandon mensinga, joined by my lovely co host, Bethany Ayers, how are things going? Bethany, I'm just tired. Yes, I can imagine you've had a very dramatic week of activity.

Bethany Ayers 0:20

Yeah, going back to full time work, balancing and juggling everything. And then also, I was in Manchester yet again. This week. We had our MBR, then we had customer advisory board, then we had a customer dinner. And then yesterday was our altitude X, our corporate event. And I was speaking at the event, but I was the second to last speaker, and so I spent the entire day being nervous. My brain wasn't so nervous, but my body was so nervous. I have my new Apple Watch 104 105 beats per minute for six hours.

Brandon 0:57

That is not good. So off the back of that full week, you are destroyed.

Bethany Ayers 1:01

I thought I'd talk about the talk a little bit today, because it was interesting. What our marketing team decided to do was not a traditional event where it's all about the product and all about our vision. We did a little bit of that, but most of it was a leadership summit. So we had people talking about curiosity, and we had somebody from the co op who talked about her journey and her relationship with alcohol and being an empathetic leader. It was fantastic conversation. And then we had Steve Perry, the swimmer. He's like, larger than life, Scouser. He was after me, and then my talk was about how to do everything, but it wasn't about my time saving hacks or like, what AI tools I use. It was more about why do I do as much as I do? And then what are the principles that enable me to do it with as little stress as possible. I thought I was winning at this, but in our chat before we started today, Brandon, you said that you could see the heaviness of the world sitting on me. So maybe I'm not.

Brandon 2:10

We've worked together now on this podcast for about a year and a half, and for the duration of that period, there's been a light effervescence that's pervaded the aura of Bethany. And I think over this past month that you've been at peak, I've seen a marked difference in the sense of does seem to be some level of burden or responsibility on your shoulders now. And I could be like over interpreting, I don't quite know, but it feels like it's true. So it must be true,

Bethany Ayers 2:34

true and depressing. I thought I was like keeping all of that lovely, hard, worn effervescence of the last 18 months with me, and that's what I was talking about yesterday on stage. But it was well received, and I was interesting. It always is nice to do these talks, because it makes me think about stuff, particularly now that I've added peak to it. So peak board seats, podcast, children, although I have outsourced children for the most part, writing class, book group therapy, maintenance therapy at this point, but like all of those things, take time, and I have to balance it all. And part of why I do it is because we only have one life to live, and I want to live mine to the fullest. And I was actually very influenced by Markham hides article. Remember Markham, who we had on the podcast around the life ruining power of routine and the idea that our brain just doesn't remember routine. So does it matter if we have a long life, if we can't remember it? And so I want to remember my life, and I want to have loads of different experiences, and I do feel how finite it is I had, I can't remember if I mentioned this, but had another friend die last week. It was expected long relationship with cancer, but that's my third this year, and I have a relative who's not doing particularly well, so I'm kind of expecting a fourth in the next week, which just really brings home how finite it is, and when you just don't know when it's going to happen. So I want to use my time as fully as I can. I think fully would probably be the best word, but I don't want to be stressed and burdened and suffering through that time. I want to be stimulated and joyful, light and effervescent and laughing, and so I have to maybe revisit what's happened to me in the last month, because I thought I was still light and effervescent and joyful. And then, rather than talking about time saving tips, I talked about some of the principles that I have uncovered that have enabled me to fill my life with as many things as I have with relatively less stress, the control and not the control of stress, but the letting go of stress and worry is my most recent discovery, and that's happened over the last 18 months. And it's interesting that you say you can feel. This burden on me, because I can't feel it. I feel pretty relaxed, I think,

Brandon 5:04

yeah, I mean, just to clarify, it may just be the tiredness, which is not carrying a burden, you know, that's just physically being tired, because you just have to do a lot of shit, basically, you know what I mean. So that could be a different I might be seeing something else here, if that makes sense,

Bethany Ayers 5:17

that's true. And also, I haven't been using my zip. I've had no time for it. So it might just be that all I need to do is a little bit of electricity on my face, and it'll all be okay.

Brandon 5:26

Purely beauty related products that I'm seeing, the lack thereof,

Bethany Ayers 5:30

I'll use it next week, and then you can tell me next Friday what you think. Light never

Brandon 5:34

vested coming back, right?

Bethany Ayers 5:38

I'll, uh, facial electricity, a facial electrolysis. Yeah, electrocution. Anyhow, I'm speaking about three areas in general. One is boundaries. I'm much better at saying no to things and saying yes to the things I actually want, rather than yes to the things that I think I should want or I should do, and that has only been possible for me through strengthening, improving, strengthening my self confidence and self trust, because you have to be really confident to say, No, I'm not going to that meeting, or I'm not doing that thing, even if you know you're going to be disappointing other people, or even if it's an expectation that you should you know there are times when I get like, the guilt, the fear of expectation get the better of me, and I do things and say yes to stuff that I don't want to do. But on the whole, I'm much better at that, and I'm also much better at taking some time to re evaluate what I'm currently doing, and deciding which things I don't want to do anymore, and saying no at that point, and giving myself permission to have committed to something and then realize I don't like it or I don't want to do it right now. Pottery, I mean, doesn't sound like that big of stakes, but I was doing pottery and realized that I wasn't enjoying it because I couldn't dedicate the time I wanted to. And so pottery is on pause until some other point in my life when I can spend hours a day on many days in a studio. So

Brandon 7:13

just a quick question, like when it comes to the work role, work can be a vortex, as we all know, and being able to make choices and decisions as to like what you delegate or what you're involved in versus what you're not involved in, especially as a CEO, is very hard, and I find myself always on the slippery slope of being sucked into that vortex never to be seen again. So I'm just wondering in your talk that you gave any kind of hints around that, because I suspect our audience that's listening has similar issues.

Bethany Ayers 7:40

I didn't I mean, this is definitely an issue I have. I didn't go into that level of detail. It was more personal around I realize I'm delegating a lot right now, basically, in a nutshell, I might have to reflect on that before going into more detail of my thoughts on it, but I think I am legitimately delegating at the moment. I'll tell you in another couple

Brandon 8:02

weeks, right? So you see how it goes. You see how it goes, yeah? See

Bethany Ayers 8:05

the impact of that. So through building self esteem, and how I've done building esteem is, as you know, and I've talked about five years of therapy to fill up my core and get me to the point of being a normal human, which is most of my 30s, and then moving into my 40s, maintenance therapy, all of the work that I've done in embodiment, lot of reflection, some sleep, and also being able, at that point to both accept external validation, look at it, not rationally, logically, and be like, Yep, I keep hearing the same things about what I'm good at. I think I can believe that those are things that I'm good at, and let those come in. And then the other part is trusting my intuition, my curiosity and life force. I know that sounds a bit over the top, but a perfect example is going back to peak. I had a conversation and was excited, and by the end of that dinner, I knew I was going back, and I trusted myself that that was the decision to make. And I didn't, then torture myself for ages. I just decided that I was going back. And every time I have followed where I wanted to go, it's led to good things. And so I have empirical evidence that following my desire leads to goodness. And then the final area that I was talking about was letting go of stress and worry, and that has been the last 18 months. I did a workshop with Al Kenny, and one of the people that he had in the workshop came on and said, stress is what happens when what we want doesn't match reality. It's a really easy sentence, and it was just struck me as so profoundly true. And it was one of those moments, and I suspect. To have heard something like it before, but it's just like, Yes, this is absolutely true. And so therefore, you can avoid a huge amount of stress by accepting that what you want is not the same as reality. And then this is where the Serenity Prayer, you know, from AA comes into play. And I love the Serenity Prayer, and I can't believe it's not in the Bible. And for those of you who don't remember or don't know what I'm talking about, it is God grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to tell the difference. And I'm just living by that. So every time I have this moment of stress, I can take a moment and go, Okay, can I change it? Yes. How am I going to change it? No. How am I going to accept it? And therefore the stress goes. And I think of stress as acute worry and worry as kind of chronic anxiety or chronic concerns. And so worry works the same way as stress, except that it's just things in the future that you can't control, but You've tricked yourself into thinking you can. And so worry for me is the same. It's like I'm worried about paying my taxes. That's a real thing that I can control. So what am I going to do today to have the money to pay my taxes at the end of January? I am worried that my children are not going to launch successfully in the future and have fulfilling lives. There is very little that I can do. Or I'm worried that my children are going to have strokes, or I'm worried that my children are going to get cancer. There are certain things I could do today to give them the best position, but there's no point in worrying of those future realities possibilities, because there is zero that I can do about that, and so that I just let it go. And that was basically my talk, which is why I was exhausted after the end of it,

Brandon:

a skill that you have, I think very clearly that I think a lot of others don't. You have confidence in a way that you didn't have, perhaps previously in your earlier life. You follow your intuition as to what guides you moment to moment in some ways. And I think what that means is you have an ability to step into a situation and you're on and you can deliver and you can respond. And a lot of people aren't like that. And I would say for myself, I struggle with this, because when I get ready for anything that's in any way important to me, I always take time to prepare for it, to think about it, to that there's a level of time spent, energy spent to ensure that I think I can pull them off in a way that's useful and effective. And it personally might be related to confidence, and personally might be related to my not trusting my instincts. I'm probably more of the norm than you are, I think, to be honest, and in doing so, what it means is I can't handle the number of activities that you're doing right now. I think if I was doing what you're doing, I think I would just like die in the sheer effort of trying to get it all done. No.

Bethany Ayers:

I mean, I think that's probably fair. I don't prepare for much like I did. Prepare for the talk. I felt I was under prepared, but then it went well, we're all just lucky for how we're wired. And I do have a fast processing speed, and I've always been able to connect the dots very quickly, and I've always been able to see things clearly. And now I guess maybe as I've gotten older, I just trust myself more. So sometimes, particularly when I was younger, I would actually berate myself for being lazy, because I would see all these other people putting so much effort in, and I was like, oh, what could I achieve if I put more effort in? And as I've gotten older, I realize it doesn't actually change my quality of performance that much, and therefore I put in the minimal effort, but can do many more things, because my quality of performance is the same or marginally better, but not enough, versus the effort that I put in.

Brandon:

We have got a topic today which is executive compensation and option grants and what to think about as a CO and we have a great guest for this. It is Daniel Harris, and he is a partner at PWC and an expert in all things option grant, share oriented. So before we get into our chat with Daniel, I just wanted to go through a couple things with you. Bethany, so the first question is, when it comes to option grants, and for you, as a CEO, joining a company and negotiating terms, what are the terms that you should be thinking about and looking out for the

Bethany Ayers:

time to vest? So in generally, four years, I peak at two years, so I would like to try and get as many options in the first two years as possible. Is there an acceleration at point of exit? And trying to negotiate to have an acceleration so that two years in, I get four years worth of grants, rather than two if we're bought or IPO, magically, this. Strike price. So the strike price is how much money will it cost to buy the options or to exercise my options? And strike prices in the UK used to be 1p 2p and it was absolutely fine. Now the HMRC have changed the rules for a lot, and strike prices end up being much higher, and therefore buying the options can be a serious outlay of money. It's a higher risk whether or not you're going to get a return on

Brandon:

the strike price. This is such a fascinating topic, because I feel like we need some actual evidence or data to suggest what the HMRC is actually up to here. But all I know is, every deal I've ever signed on to strike prices have always been one pence, two pence. And that's phenomenal, because the value that's sitting there for you as a new employee, coming to that company is wonderful. The market valuation post series A is two pounds per share, so you've already accreted a value of one pound and 99 Pence in that case, conceptually. So, so that's your starting point by which you create even more value. And I think the reason why that's tremendous for everyone is because the company can deliver more value back to you as a potential employee and attract you in ways that are phenomenal, because you realize the potential value that you're actually kind of accreting straight out of the gates. Conversely, I've also seen other companies where they don't want to do that and they say, Look, our HMRC strike price is one pence, but we're going to give you the actual series, a market valuation rate in that case, and you need to now increase our value from that point.

Bethany Ayers:

Yeah, that's not cool. I had just realized we now have significantly more US listeners than we do UK listeners, so we should start to translate things a little bit more. So HMRC is the UK's IRS and companies can set whatever strike price they want, but there are tax implications. If the HMRC has said that the strike price is two pounds, and you set it at 1p you actually end up having to pay the difference when you exercise it. And I think it counts as income. This is why you should talk to Daniel Harris and not me about your tax implications.

Brandon:

By the way, I've never seen a company do that where they would set their strike price below the HMRC number.

Bethany Ayers:

You could do it for your employees so that they basically could actually benefit, you know, but understand that tax implication. I haven't actually seen companies do the other way that if they've gotten a good valuation for the HMRC to then raise it. That's just a bit shitty. I

Brandon:

actually experienced this myself personally, where they had a strike price of the pens and they were giving me market value at the round level, effectively saying to me, Brandon, you weren't responsible for delivering the previous value or the valuation. We're hiring you to get us to a higher valuation, and you should get that, and that's fair. So their point back to me was that you need to now deliver something useful to us to get a higher valuation.

Bethany Ayers:

You know, it's still like you're trying to attract top talent, and top talent want to make money, but it would just be a bit of a red flag for me that they're a bit selfish and greedy, and how else are they going to run things and not seeing the big picture of what the impact of a top executive can do to their business. But then also, if you do end up leaving before there's an exit, and you can't sell your secondary to the next round or two, you're massively out of pocket, and you're really having to bet that there's going to be an exit that is significantly higher than your most recent valuation. And also, as we've seen in the last two and a half years, who knows what's going to happen in the future.

Brandon:

So just on the question of the secondary sale, this is really interesting one, and I feel like previous companies I worked at, everyone has been caught out on this, including the finance leader, which is they didn't realize until literally, the round was happening, where the lead investor had said to the company, Hey, we love this company so much. We want to buy more shares than what's currently available. We want to dive into the employee pot and grab some of those as well at this valuation that we're currently setting. And what the company realized at that point was that, due to their articles of association or reasons that I can't even understand, the employees in the company cannot participate in the secondary sale, and people that had left the company, which was me in this case, could participate in the secondary sale. So it was just this bizarre kind of outcome whereby existing employees cannot participate in the secondary sale. And I think it feels to me, in retrospect, thinking about that situation, it seems very important if you're joining the company, to ask questions around secondary sales specifically,

Bethany Ayers:

yeah, I'll add that one to my list of what to negotiate and what to look for in an agreement. To be fair, I hadn't actually thought about that one, but you're right. It's a really good point, because secondaries is probably where we're going to make most of our money nowadays.

Brandon:

It feels like it. I think you're absolutely right. I mean, if you think about the average exit for these series A companies, you're looking at eight years, 10 years, I don't know, it's some number of years that is more than four. Definitely. The other thing that you sort of touched on, I guess, was the exit is not anytime soon. You've been there for two years, three years, four years. Have a certain number vested on. Options, and you've put in your contribution to the company, and you're deciding to leave at that point. And obviously it's very important that you can leave that company with your vested options and purchase them as shares. And it kind of like tips around the space in terms of being a lever.

Bethany Ayers:

There are all these things that I did not think about to my earlier conversation, of being super prepared about everything, clearly not seeing what kind of lever provisions are there. So is it a default that everybody is a good lever unless something horrible has happened, or is it that the default is bad lever, unless the board decides you're a good lever, it's always board discretion, and they'll have something that says board discretion. But what you need to understand is, what is the appetite and philosophy of the company that people are perceived as good leavers, unless they do something egregious. And you can also just ask of the people who have left, how many have retained their shares?

Brandon:

Yeah. So I have a personal experience with this many, many years ago, which kind of made this apparent to me. There was an individual that had vested shares at a senior C suite level had decided to leave that company, and the board decided, with their discretion, that he was not going to get them, basically. And it stuck with me ever since, obviously, in the sense of, okay, good leave or bad leaver is very, very important, because at the end of the day, if a board member decides that they don't like Brandon for whatever reason, and I'm leaving the company, what I don't want to have happen is obviously that board member that doesn't like me voices that opinion says, No, he should not get his vested shares. And you know, that'd be a terrible scenario. So to your point, I guess some gut checking, do they give their levers with the bad lever default? Do they end up giving the vested options? Number one? Number two, what I've actually done in the past is, as the COO is, I've gone to the board post being hired with a resolution with the VP of Finance, saying we should switch this to being good lever as the default. So I think, as the capacity of COO, I think you can and should be in a position where you should feel confident to make changes to the program that you think are in the best interest of everyone, including the investors and the board and the rest

Bethany Ayers:

of the company. In that respect, absolutely I agree. And then that was making me think about one other that I don't know whether or not you can negotiate on, but I would highly recommend it if you can, which is how much time you have to buy your options after you leave the company. So I think the default is 90 days, because it'd be really nice if it was like whenever, like it isn't. You normally have to decide whether or not you're going to take a gamble. And

Brandon:

actually, on this point, getting back to the previous discussion around the strike price, if you're like me, the strike price was high and not the HMRC value, but in fact, some artificial value of whatever it was, it meant that for me to buy my vested option, it was gonna be a shitload of money out of my pocket, basically. And for me, is a decision. It's very difficult, because the one side of it, I've earned those vested options. I believe in the company, but it becomes like a question about belief, almost, where, like, will this company exit? Will they exit at a good valuation? This large tranche of money that I'm putting into the company now to buy these, these options, is, I feel like I'm like a real I'm like an angel investor. I'm putting in like 50 grand to this company to get a payoff, basically. So one of the key considerations, in addition to being able to purchase your vested options as shares within the 90 day window. Is also the option to hold them in as options in perpetuity, which means that you can leave the company with your options, not convert them into shares, but yet you hold onto those options upwards of a 10 year maximum limit from the HMRC, and that is a valid option that I've had in the past, that I've actually pursued as well. And the difference there to recognize is that if you purchase your options as shares within the nine day window, that will be subject to capital gains, 20% tax. If you hold on to them as options, whereby an exit event occurs at some point in that 10 year period, you are then subject to income tax, the regular 40% or 50% tax, basically. So there was a tax implication difference to be had, but this is what I had to weigh up in terms of the decision making process myself, in terms of out of pocket, angel investing, risk versus tax outcome, which obviously isn't great.

Bethany Ayers:

I didn't realize that. Thank you for sharing. I've learned something today. So

Brandon:

let's park it there, and let's move over to our conversation with Daniel Harris from PWC.

Dan Harris:

Clearly, early on, kind of startup phase scale up that often as you think about that businesses, one need to get people over the line and through the door to be able to go on that journey. And the reality is, they will very unlikely have lots of cash knocking around. So in terms of your compensation package, it's going to be relatively low, base, limited bonus opportunity. It's all about the equity upside, and often. I think traditionally, you come in, you with us on the journey, and then when there's a liquidity event, you will participate in that. That was how it operated. It feels to me like there's definitely, over the last few years, more of an inflection point, I'll call it around Series C and D, as businesses become more mature, potentially moving into profitability as a revenue generating business, is that now actually you're moving to a stage where in order to be able to recruit but also retain the right caliber of individuals, there's a level of vesting that is required to be given ahead and potentially in advance of a transaction, so that people, candidates coming in will want that, and so you will construct your schemes more around time based, I guess, is the reality, as opposed to just exit based. So you're moving through that transition from exit based, probably to slightly more time based, but still with the majority, I'd say, based on a liquidity event, such that by the time you move into a PE environment, I think then you're becoming a much more mature business, and probably you're starting to change the mix of compensation. Potentially the business is able to afford maybe more market rate salaries, potentially bring in some form of bonus, the equity upside still there, and definitely more exit based but there will be an element of vesting as well. So it's really that risk group. Really that risk reward profile starts to change as you go through that life cycle. Clearly in most PLC environments, for example. And it's arguable that the risk reward profile is not as high less risk, because you're coming into a very much mature business. And now I'm going to get paid every month. I know there's an annual bonus in play if we meet our target. So there's a clear plan there. And actually, if I can deliver on my three year LT targets, I'll also get a payout every three years,

Bethany Ayers:

and just to anybody who hasn't been in a corporate environment. And LTIP is a long term incentive plan, and it is the share scheme at PLCs. So that's just actually reminded me of something else that I get asked all the time. So as an American expat in the UK, New expats who are negotiating either their UK job or something in Europe will send out a message to one community or another. Now we can plug the COO round table as an example of one of those communities and say, does anybody have a good expert who can help with UK US tax implications around options? And the answer is generally no or yes, but outrageously expensive, so you're going to spend all of your money you're going to get from your options on the advice.

Dan Harris:

I think one, getting that on the table early on is really important from a candidate perspective. Actually, I'd argue that it's incumbent on the employer to do a lot of their legwork on that, like they've got to make the package appealing for you. And that package has to be appealing on, obviously, on a gross basis, but also as you think about it in terms of, well, okay, what are the deductions that might arise? And without giving you too much of scare stories, we do see scenarios where it gets to an exit, or close to an exit, suddenly it comes out that one of the execs is a US taxpayer, and the 10% tax rate that they thought they were getting all of a sudden becomes 40 or 50% and what we say to sponsors of all types, VCs, P has, etc, is the reality is you're probably going to have to end up sorting this out, because we need to keep the management team on side. So it's in everyone's interest to have that discussion up front, because there are things that you can do to make sure that not saying you're avoiding tax, but I'm saying it's getting clarity up front on what the tax position is, and can we make that, you know, as efficient as possible in the circumstances, because it's going to end up costing someone. And actually, it's better to have that discussion up front.

Brandon:

If you think about series a company, from an employer standpoint, what would be your top five things to recommend in terms of how they structure that program, what is the business

Dan Harris:

plan? What have we just sold the story to investors on? And start aligning our incentives to those so if it's about getting to a fundraise in the next three to four years, thinking about how we're going to build our construction around that, which generally is going to be, as I said, low fixed pay, but upside on the variable, and that is effectively through your equity package. So it's thinking about, right? Are we just going to say that this is based on you will share in a liquidity event? Key question then is, what is a liquidity event? Do we want options to crystallize on? Let's call it a minority investment. So if we're only going to sell 20% I've seen quite a lot of that recently, where actually management decided that, because of the environment, they weren't necessarily able to do a whole company transaction that they probably initially anticipated. They were just going to allow management either to take some money off the table or, more importantly, do sort of an interim funding round, and in doing so, allowed at some four. Of secondary so that management are allowed to sell some of their vested equity when it got to the option plan, though, it didn't allow for that kind of moving on to the problem, but for the solution. But it's thinking about that up front. We see these horror stories, and then, therefore, start to plan these things. So what is an exit? Is the key thing for an employer to think about, how are we trying to align our interests, the interests of myself as a founder with the management team and make sure that everyone is on board. Because no one likes a mismatched arrangement where the founder makes off and the management team don't. That's not going to work. And then thinking about equity is valuable in terms of there's only so much to go around. So start planning how they how your all child is going to look over the next couple of years. What are the recruitment plans, and starting then to sort of build that out in terms of, okay, so what can I give away? What do I need to give away today, versus what do I need to hold back? And then overlaying that with, obviously the jurisdictional piece as well that we just discussed. So where are we likely to need people,

Bethany Ayers:

which, of course, begs the question, what does a good one look like, like? What should everybody know for negotiating?

Dan Harris:

I think times have changed in terms of particularly where we see longer hold periods. So the reality was, you might see a typical hold period being three to four years, and a lot of people were prepared to commit their time to that where things are being pushed out. And the recognition that actually, to get this to the valuations that you might need. It could be a five to seven year play. People coming in need to, you know, understand what they're committing to in terms of, I'm going to give you four years. They don't want to walk away with nothing. So if I'm along for a journey, but actually, my job is done at a particular point. I've taken it to the next stage of putting the building blocks of what's needed. You don't necessarily need a me. I quite like to go off and do something else, and I don't want to be sticking around just for the sake of getting the equity, because that's probably not good for the business, as well as myself. So thinking about getting either certainty or vesting and or your lever provisions such that in that scenario, you can say, right, I can walk away. Probably not going to be able to sell your equity at that point, because it's not necessarily cash knocking around, but at least being able to feel comfortable that you've left a business in a decent state and that you get to keep your equity, they're probably the two killer points, really, for me, in terms of vesting and levers. I mean, obviously, other than the big thing of the amount of what you're getting, you know,

Bethany Ayers:

absolutely and the strike price, it's something that you really need to think about, which is just how much do you have to spend to buy your options again?

Dan Harris:

There's some philosophical views on this as well, in terms of founders and how they want their management team to participate. If you're coming into the business at a particular stage, it's progressed, and you've recently got a an inflection point. From a valuation perspective, we want you to be accretive and grow the value of the business from today. So you're not getting any of the inherent value. You're only participating in future value, and therefore that informs the strike price. Then often it really comes down to one negotiation in terms of the quantum of the option package. I don't think many companies really rely on the strike price in terms of the money coming in that's not part of their business model. And so really, you can deliver more value by having a lower strike price, is the reality. And then often there's tax implications of doing that. So you kind of balancing those two. And I think what we are seeing more and more is that that strike price is getting reduced to effectively, as you say, Brandon as a nominal value as the business progresses,

Brandon:

it's such a funny business, because I feel like with the strike price being set higher, you're in the situation where you're with the organization for two years, three years, you decide to leave the organization, and with a program in place, generally speaking, You can purchase your vested shares at that strike price. And if the strike price is extraordinarily high at like a pound or two pounds, and you're a CEO with a huge amount of vested options, your out of pocket to buy them is massive. So you're almost becoming part of that venture capital risk profile by laying out 100 grand to basically kind of purchase them at that point. And I'm just wondering, how should I as an employee going forward for organizations, how should I think about this in terms of trying to get the best deal for myself, recognizing I don't have a limitless pocket of spending or buying shares, in this case,

Dan Harris:

putting aside tax for a second. I guess this sort of goes down to the negotiation point in the sense, you know, I talk about vesting and I talk about lever provisions, because almost in your scenario there, you're basically prohibited from exercising whether it's a tax bill or a strike price. Either way, you've got to fund that up front, and you have no certainty of when this business is going to exit, how it's going to exit. So I think, in my mind, that the sort of the better view is to make sure that you're just allowed to keep your option package, and I appreciate, as I say, that could have certain tax implications, particularly where it's EMI and you're not an employee, but you go into a scenario where actually, either I'm effectively, potentially taking a third party loan to fund this, when I really have no visibility of when it's paid back, or you. I couldn't lose it all, quite frankly, because I'm not, I'm not going to take that risk,

Bethany Ayers:

and also not just any individual themselves as well, because most founders end up with options as part of their so they'll have some of the company they still own, and then the rest will be options. So that's one of those where it's quite nice to be aligned with the founder and make sure that you're all negotiating as a exec team together coming in to a new business, and you're negotiating, and the company comes back and says, Well, that's not our standard share scheme. This is our standard share scheme. We can't do anything about it. Is that true, or can they create a new Share scheme?

Dan Harris:

I think there's always an ability to have a conversation. You'll find some PE houses, probably more than VCs, are very standardized in terms of approach, but there's no hard and fast rules on these things. And I think you can always, you're always open to a conversation it comes down to your negotiation leverage that you'll have, whether that's particular tax circumstances or just commercial ones. And generally, that kind of comment we see is driven by tax. Is the reality in terms of the way that you structure things, and there's this cost benefit to go through. Ultimately, it's an employee incentive. They need to decide whether they're going to make the investment, if you like, for you and maybe others. So

Bethany Ayers:

it was interesting, you said that in the early stage, you're still seeing Cliff vesting. Because I haven't seen Cliff vesting in the market for ages like it's mostly time bound. But there is starting to be a bit of performance based vesting as well. Brandon, I don't know, have you started to see that? Like milestones hit, historically,

Brandon:

for the most part, adventure, early stage, everything has been time based. And I think what I'm starting to see bleeding down into venture now is less time based and more performance based.

Dan Harris:

In the shorter term, these things around performance conditions then become really difficult, because one you've now created a bit of misalignment, because some of the management team members subject to certain targets might think, well, actually, we're just taking some short term pain here in terms of EBITDA or whatever, to make decisions so we're not necessarily aligned, and that becomes problematic, and then you can spend a lot of energy, both emotionally and physical, having some sort of renegotiation, which is a complete distraction to the business. Quite frankly, you just want management align and focus. You know, we always these cliches of, you know, what's a good incentive? It's about it gets me up in the morning, not keeps me awake at night. And

Bethany Ayers:

so your recommendation is to not have performance based vest thing.

Dan Harris:

You can have performance by investing, potentially based on some sort of Ratchet equity ratchet, let's say, but when we get into the minutia, maybe revenue, margin. EBITDA, I think sometimes, as I say, it's not say you can't do it, but I think people have to recognize that things can change, and that you need to be alive to that and self aware that if you're doing that, some people around the table might be thinking, Oh, what's this going to do to my incentive and be on the front foot, so that you get people comfortable that there is a governance process in place that can then sort of reflect on that and maybe make amendments. But as I say, I just find that then that takes up, can take up a lot of time, and just question, is that really appropriate? It's kind

Bethany Ayers:

of like sales commission schemes, no matter how easy you think it's is and how it's going to drive the right behavior. Something always happens that drives weird, funky behavior. I've ended up with situations where it's a combination of time and very clear milestones, like successfully finishing X round or hitting X, A, R, R, and so it's not like loss of different little deaths by 1000 cuts kind of thing, but a very clear, easily defined and is also normally a kicker, rather than part of what I'm negotiating is my percentage to begin with, I guess, As an employee that doesn't feel bad, that feels fair.

Dan Harris:

And I'm definitely advising clients quite a lot around those types of models, actually, interestingly, both in the listing environment, but also in venture as well. I've been around investors sometimes with something not dissimilar to that. And people have said, You're confused now, you know, it doesn't make sense. It's got to be time or performance. You can't have both. But I'm like, No, there's a level of retention here. People need to know that they're going to get something just based on being with the business, continuing to deliver in terms of their role. And obviously, if people thought they weren't performing, there's performance management issues anyway. But they also want to know that there's a level of equity upside if they can help deliver and getting that balance, I think, to me, is definitely a better model.

Bethany Ayers:

In VC world. Quite often it's being acquired, particularly now it's a full acquisition by a bigger company who's hoovering you up for some reason, and so in that. Situation, let's say that some options are accelerated, but some are not, for whatever reason. Who benefits from the ones not being accelerated? And I assume they go back into the option pool, and then the option pool no longer exists. So that means that everybody's slightly less diluted. So ultimately investors benefit, or is it a view that the acquirer benefits, because they can then incentivize the management team to stay, or they're going to incentivize a management team with their own structure? You can see these, you know, I'm just trying to figure out how all this

Dan Harris:

works. I guess in that certain scenario, my experience is more that there's a level of what we would call earn out. So there'll be some cash up front, but then there will be payments over the next three years based on performance of the business.

Bethany Ayers:

And that earn out is separate to anything you've negotiated as part of your options, because that earn out will be the acquirer coming in and restructuring something so that you will want to stay

Dan Harris:

correct well, so there's sort of a couple of stages here. So one, I've got my original option package that vests on the change of control. I'm now a shareholder, and alongside my other shareholders, including the founders, we're selling to our acquirer, and they're selling for X amount up front, but maybe x amount over the next three years based on performance of the business. So you're now being sort of incentivized as a selling shareholder for the value that you are selling, and being really clear on that, I think you know that brings with it so often its own challenges as to can we keep our own culture and deliver versus actually, we're just going to get integrated into a large corporate and we're going to lose a lot of the magic that we did to get to this point, and often the institutional investors will just take cash at that point, the sponsors, the VCs, will just take cash and walk off. And this is more from a corporate perspective. How are we integrating these people into the broader comp structure, if you like. Final question

Bethany Ayers:

is, out of everything that we spoke about today, what is the one thing our listeners should take away from our conversation?

Dan Harris:

I think it's going to the conversations, particularly with prospective employees, with your eyes open, because these things are complicated and they require a lot of understanding up front too often, people a year down the line turn around. So I'd name this if I'd realized this, I could have got the tax set up and almost the horses bolted at that point. You've got to be really comfortable as you go in. This is an important part of the package. This is why you're going people talk about be really clear, have the conversations up front using network.

Brandon:

So I will keep my eyes open as we close off this episode of the operations room, so thank you, Dan Harris for Joining us, and we will see you next week. You

Show artwork for The Operations Room: A Podcast for COO’s

About the Podcast

The Operations Room: A Podcast for COO’s
We are the COO coaches to help you successfully scale in this new world where efficiency is as important as growth. Remember when valuations were 3-10x ARR and money wasn’t free? We do. Each week we share our experiences and bring in scale up experts and operational leaders to help you navigate both the burning operational issues and the larger existential challenges. Beth Ayers is the former COO of Peak AI, NewVoiceMedia and Codilty and has helped raise over $200m from top funds - Softbank, Bessemer, TCV, MCC, Notion and Oxx. Brandon Mensinga is the former COO of Signal AI and Trint.

About your host

Profile picture for Brandon Mensinga

Brandon Mensinga