For decades, a key part of the success of Silicon Valley companies has been employee ownership. Granting stock options attracted the most talented employees and motivated them to work tirelessly in pursuit of an IPO enabled cash-out. Now though, private companies are staying private much longer and so the appeal of stock options is diminishing. Because of the recent market volatility, more IPOs are likely to be delayed, further dimming the hopes of employees looking for public market liquidity . Faced with that reality, what are smart private companies doing to reestablish the lure of equity ownership?
The Valley's Secret to Success
Traditionally, a Silicon Valley start-up would allocate roughly 20% of its stock to its employee option pool. Key employees, through option grants, would own a recognizable percentage of the company. The employees’ objective was to build the company and get to an IPO as quickly as possible. In 2000, the average time from formation to an IPO was just six years. At the IPO, options would become liquid and the sale of the underlying shares could create real wealth for employees. To make that happen, employees were completely invested in the company’s success and gave their all to get the company across that IPO finish line.
By contrast, public companies could only offer a small number of options on shares that would appreciate minimally. Compensation was therefore almost entirely focused on salary and bonuses. Consequently, those seeking stability in the form of a solid 401(K) and good health insurance went to work for a big public company like Microsoft. Those looking to create wealth and build something exciting went to work for a disruptive private start-up like Dropbox.
Over the years, Silicon Valley start-ups seem to have consistently outperformed the big public companies. Their success can be attributed to multiple factors, but it’s clear the incentives and culture of employee ownership and the kind of people they attract are a big part of the reason why.
Then Options Lose Their Appeal
Over the past decade, the world changed for Silicon Valley start-ups. For several reasons, start-ups started staying private much longer. Today, the average company is 11 years old when it goes public – not six. Compounding this trend is the fact that there are now far fewer IPOs compared to years past. In 1999, 188 technology companies went public, but in 2014 there were just 55 and given the number of IPO's this year, 2014 may be remembered as a banner year.
As a result, the value of stock options to employees has been materially diminished when compared to years past. Employees understand that when an IPO is less likely, the value of their options is greatly reduced. And, even if they are confident of a start-up’s IPO chances, waiting for more than a decade to share in the value they are helping to build is unappealing. A 25-year old engineer isn’t excited about waiting until his or her late-thirties to buy a house. He or she is also unenthusiastic about the risk associated with keeping the bulk of their net worth tied up in a single stock for many years.
Meanwhile, mature, publicly traded tech companies are sitting on mountains of cash. They offer big salaries and bonuses, offer amazing health care, and provide luxury buses to work and nap rooms when they get there. Without stock options as a meaningful incentive, most private companies can’t compete with that kind of current cash compensation and perks.
As a result, private companies are increasingly at a competitive disadvantage in the fight to recruit the best employees. If you’re a talented engineer who could work anywhere, why take a chance on an uncertain IPO a decade from now when you can get paid significant cash annually at one of Silicon Valley’s large, publicly traded tech companies?
Liquidity is the Answer
To regain the upper hand in the recruiting wars, the smartest private companies are enabling controlled secondary liquidity to give stock options value again.
There are multiple forms that liquidity might take and they tend to correspond to the maturity of the company. In the earlier stages, companies can informally let employees seeking to sell their stock know the types of buyers with whom the company is comfortable. Increasingly, companies are relying on intermediaries like SharesPost as a way to offload the work of executing these transactions smoothly.
As the volume of secondary transactions increases, companies create more structured programs. One version has become known as a “ROFR” or Right of First Refusal program.” In a ROFR program, the company or its agent keeps a handful of deep-pocketed investors up-to-date on the company’s financial progress. As employees come to the company looking to sell their stock, the company refers them to these ROFR buyers and provides approved forms to implement the transactions.
The largest private companies – unicorns – also run formal liquidity programs. Generally, these take the form of a tender offer funded by the company or a company selected institutional investor. Leveraging a platform like the NASDAQ Private Market, the company proactively invites large numbers of employees to sell at a set price. Restrictions on the number of shares an employee might sell ensure that employees remain vested in the success of the company over the long term.
These strategies, each in their own way, turn stock options into cash for employees. Instead of viewing options as a lottery ticket gathering dust in a desk drawer, they become a down payment for a house. Not someday, but sometime this year.
The Bottom Line
Employee stock options can be a powerful way to recruit the most talented people to a private company and motivate them to do great things. But as these companies began to push back the timeline to an IPO, those options began to lose their appeal. Leading private companies are breathing new life into equity incentives by offering some form of company controlled liquidity.
Greg Brogger is founder and CEO of SharesPost, Inc., parent company of SP Investment Management, investment advisor to the SharesPost 100 Fund. He is also the founding President of the NASDAQ Private Market, a joint venture between SharesPost and the NASDAQ OMX Group, where he continues to serve on the Board.