Thursday, March 20, 2008

Do 4 Year Vesting Schedules Still Make Sense?

Four year vesting is one of the sacred cows of Silicon Valley. It is a birth right. A practice that can not be questioned. The persistence of this labor friendly term in start up comp plans would make the Teamsters Union proud. When it comes to pay packages in Silicon Valley, everything is negotiable EXCEPT the length of stock option vesting. That has to be 4 years. But does this make any sense? On balance, I don't think so. At least not any more.

During the dot com glory days, it was possible for a venture backed company to be formed and go public in 4 years or even less. Of course, many of these businesses were woefully unprepared for public market scrutiny and subsequently failed. But the idea of a 4 year vesting schedule was palatable when a start up could reasonably expect to be pubic in that period of time. Those days are long gone. It takes closer to 7 or even 8 years for a successful company today to go from launch to IPO. So what happens to all of those employees who are fully vested at the 4 year mark? That is an issue many VCs and boards, Clearstone Venture Partners included, are wrestling with.

If an employee's stock is fully vested, what is her motivation to remain in the company from a financial perspective? The answer is not much. She would quite likely be better off going to a new company and receiving a fresh grant of stock options. In another 4 years, she will have twice as many options as she would have had if she had stayed at the first company for the entire 8 years. She will also enjoy some portfolio diversification by having a financial interest in two different start ups. So the value of 4 year vesting makes a lot of sense for the employees. But what about for the company?

Most venture backed companies create option pools of 20% to 25% of the total shares outstanding. The hope is that these pools will be sufficient - plus or minus 5% - for all of the employee stock option grants from inception to IPO. But imagine a scenario where most of the early employees leave after 4 years. Those people will need to be replaced. And those replacements will need new option grants. So essentially the company is paying twice for the same position. And the situation can get quite odd. I have seen companies in which the collective stock holdings of FORMER employees exceeds the amount of stock held by current employees. Hard to see how a situation like that can be good for the current employees (who are creating value for those that have left) and the non employee shareholders. Eventually, if enough employees leave at the 4 year mark, a company has no choice but to augment the option pool in order to back fill the vacated positions. These new stock grants dilute the ownership percentage of every other stockholder - from VC to founder to employee. In summary, 4 year vesting is not a very attractve compensation structure for start ups given the current IPO time line.

What to do about this conumdrum is far from obvious. Ideally, from a company's perspective, stock options would only vest when a liquidity event occurs (wheher IPO or acquisition). If that takes 10 years, so be it. There are a number of drawbacks to this approach from the employees perspective so such a solution is not practical. However, I do believe that 5 or even 6 year vesting should become the vesting standard. As the holding period for venture backed companies elongates, I believe there will be more and more board room dicsussions about what is fair and reasonable with regard to stock option vesting. It was not that long ago when 5 year vesting was the norm, and getting back to that would be a good first step.

VC Industry to Shift Focus?

These are tough days for venture capitalists - and tech entrepreneurs. For every YouTube and Facebook, there a hundred other VC funded businesses that are just limping along. Heck, some might even be skipping along (generating revenue, perhaps even profitable) but it doesn't much matter. The is precious little 'liquidity' - the life blood of a heathy start up environment. The IPO window is almost shut for all but the most impressive companies. Wall Street wants to see revenues of somewhere in the $100 million range, and profitablity, to seriously consider a company for a pubic offering. Even then, with the dramatic downturn in tech valuations, there are few buyers for these nascent tech company shares. Certain industries, telecom, semiconductors and enterprise software are particularly difficult to attract Wall Street interest. There is a sense in these sectors that the best days are passed. While not true, Wall Street bias are hard to overcome.

Many investors - and founders - have been in their companies for 6, 7, even 8+ years. They are finding that it is not enough to build a solid revenue generating company. And those of us in the start up world know how terrifically difficult that is. No, revenues and profits are not enough. The public markets must also be in an accomodating mood. With tech valuations at signifcantly depressed levels, even the M&A market is in a slump. Acquirors like to use their generous market caps to buy smaller companies. When their market caps shrink, so does their acquisition currency - and their nerve.

So where will this take us? One effect of the long tech slump (going on 8 years) is a greater openness on the part of traditional tech VCs to consider investments in alternative industries. Clean tech is clearly one such example. But there are others. VCs are now investing in such non tech spaces as store front retail, apparel and even consumer products. Where this winds up is anyones guess. But I believe a growing percentage of venture dollars will find their way to non traditional industries. Should this trend gain traction, Silicon Valley itself may become less relevant over time. To be sure, it will likely remain the largest base of VC investment. It just won't dominate as it historically has. That is not necessarily a bad thing. Southern California entrepreneurship has a lot more to offer than just technology centric businesses.